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 (PE) funds typically obtain funding from the following sources:
High net-worth individuals.
Pension funds and endowments.
Fund of funds.
Offshore investors (with appropriate regulatory approvals).
A number of domestic funds have appeared on the market, including captive PE funds of large industrial groups.
PE and VC deals (in terms of value) stood at approximately US$12 billion (for over 600 deals), with more than 20 investments being above US$100 million. The total committed but uncalled capital (dry powder) in 2014 was estimated to be US$8 billion. However this amount is anticipated to fuel the Indian PE and VC market in the coming months (source: India Private Equity Report 2014, by Bain & Company).
While 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 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 and investing in robust businesses. With the macro environment encouraging PE funds to focus on quality businesses, the supply of such businesses together with the competitive environment is limiting the relative ease with which PE funds are able to deploy their capital.
General partners are seeing larger co-investment participation by limited partners, leading to a tighter control over the portfolio investment. This development could be on account of the overall increasing difficulty in fundraising at the PE entity level, as well as general macroeconomic challenges and prior experiences.
A lot of PE funds that invested during the boom period of 2006 to 2008 are at the end of their fund cycle and are now due for exits. Therefore, the exit market is only expected to increase in the coming months, particularly considering the capital market recovery and strong inbound interest.
The number of PE deals in 2014 was similar to the number in 2013 with a marginal upward/downward trend in certain quarters. 2015 is expected to see an upward trend in PE funds seeking majority stakes in their target companies, and also a good mix of exits and investments by PE funds. It is also thought that domestic PE funds will play an increasing role in India's PE industry in the foreseeable future.
Even though the appetite for PE investment remains strong, the fundraising climate has been tough, PE funds have found it difficult to raise funds generally. Despite the current circumstances, fundraising activity is expected to continue to increase. Going forward, 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.
PE funds that are raising funds from offshore investors according to an approval from the Foreign Investment Promotion Board (FIPB) have faced higher scrutiny in the past. With the objective to prevent re-routing of funds through round tripping, by entities aiming to benefit from tax havens, the FIPB has sought clarity from PE funds on the source of funds and the identity of the beneficial owners. This had created some practical difficulties. However, in the recent budget announcement made by the central government on 28 February 2015, this practical difficulty has now been addressed. It is now proposed that foreign investment into alternative investment funds (AIF) or a venture capital fund (VCF) be permitted without the need for FIPB approval. However, the necessary amendments and regulations are yet to be declared.
Investment by PE and venture capital funds (VCFs) has been steady across all phases of a portfolio company's lifecycle. The early stage investments in India by PE and VC funds reached about US$428 million across 163 deals during 2014. Some of the notable deals of 2014 includes Flipkart raising US$1.91 billion and Snapdeal raising US$627 million in the IT & ITeS (e-commerce) sector.
The following trends applied in 2014:
Investments in the Information Technology and IT-Enabled Services (IT & ITES) sector contributed 43% to the total value of PE. IT & ITES companies were highest in terms of both investment value and volume during 2014.
The e-commerce sector continued to play a significant role in garnering PE investments during 2014. Investments in the e-retailing sector are predicted to grow to about US$2.8 billion by 2016.
The healthcare and life sciences industry was the next largest destination for PE investments in 2014 attracting US$6.4 billion with 115 deals. Foreign direct investment (FDI) in the drugs and pharmaceutical sector escalated to US$1.154 billion during April to November 2014.
Private investments in public companies (PIPE) deals have also been popular in recent years. In addition, several sovereign wealth funds have already made large direct investments. For example, US$237 million PIPE into Kotak Mahindra Bank by GIC. These investments are expected to continue to draw larger interest in the coming months, as interesting opportunities arise.
Minority stake deals are the most popular transaction structure. Buyouts are rare and leveraged buyouts (LBOs) are not permitted. With the increasing liabilities on promoters under the Companies Act 2013 (New Companies Act) (see Question 4), preference for a minority stake remains. However, PE firms are also initiating a focus-shift towards obtaining higher stakes in target companies, to back investors' needs for better corporate governance.
2014 saw about US$3.8 billion coming from 221 exit deals, compared to US$3.6 billion from 158 deals in 2013. While sales to strategic buyers or secondary sales continue to remain the preferred route with top PE exits, promoter buy-backs have also been considered.
Companies Act 2013
The Companies Act 2013 together with the applicable rules has been notified on 1 April 2014.
With increased transparency, greater checks on financial reporting and auditing, regulatory oversights and corporate governance being mandated under the new legislation, PE funds feel empowered. Some of the key reforms that affect PE funds are as follows:
PE funds in a public company will now be able to contractually agree to restrictions on the free transferability of shares in the company, such as the right to first refusal, right of first offer and tag along rights.
A new entrenchment provision, introduced into the articles of association of companies, allows for specific articles to be amended only after certain conditions and procedures are complied with (that are more restrictive than those for a special resolution under the Companies Act). This in turn protects the governance rights of the PE investors. This will enable better enforcement of the veto and other governance rights of PE investors.
An extensive definition of the term promoter to include:
any person named as a promoter in the annual returns of the company;
any person who has control over the affairs of the company, directly or indirectly, whether as a shareholder, director or otherwise; or
a person in accordance with whose advice, directions or instructions the board of directors of the company is accustomed to act. As a result, PE firms exerting control (including negative control) in certain cases may be construed as a promoter.
Several compliances have been extended to private companies that previously only applied to public companies. For example, a preferential allotment of shares, as well as an issue of debentures, is not permitted without shareholders' approval, even for investment in a private company.
The corporate governance framework has been made stricter. For example, restrictions are now imposed on directors entering into forward contracts in relation to the company's securities. Common law duties of directors have now been codified and breach of such duties can attract monetary penalties.
The scope of listed companies has been extended to include private companies whose securities (for example debentures) have been listed. Therefore, certain governance provisions applicable to listed companies may also apply to private companies with listed debt securities.
Restriction on a company making investments through more than two layers of investment companies.
Put and call options
SEBI. On 3 October 2013, the Securities Exchange Board of India (SEBI) issued a notification (SEBI Notification) validating option contracts, subject to the following principal terms and conditions:
The title and ownership of the underlying securities is held continuously by the selling party for a minimum period of one year from the date of entering into the contract.
The price or consideration payable for the sale or purchase of the underlying securities pursuant to the exercise of any option is in compliance with all the applicable laws.
The contract is settled by way of actual delivery of the underlying securities.
The SEBI Notification specifically excludes any contract entered into before the date of the SEBI Notification and therefore option agreements made before 3 October 2013 are not free from enforceability challenges.
In 2013, the Supreme Court of India clarified that the SCRA and the rules, regulations and notifications issued under it also apply to unlisted public companies (see Bhagwati Developers Private Limited v. Peerless General Finance and Investment Company (2013) 9 SCC 584)). Accordingly, the SEBI Notification also applies to an option contract of an unlisted public company.
RBI. On 30 December 2013, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Seventeenth Amendment) Regulations 2013 (Seventeenth Amendment) were issued. Further, on 9 January 2014, the Reserve Bank of India (RBI) issued a circular (Circular) dealing with the pricing of optionality clauses.
The Seventeenth Amendment read with the Circular, allows offshore PE funds to invest in shares or convertible debentures containing an optionality clause, but without any assured exit price, and an Indian company can issue the same under the FDI route. The pricing guidelines apply to such options on the basis of the instrument in question. A lock-in period of one year from the date of allotment of such instruments, will also apply.
The Circular clarifies that existing contracts will have to comply with conditions of the Circular to comply with the existing Indian foreign exchange laws. Therefore, parties to the contract are modifying their contract (to the extent necessary) to comply with the Circular and the Seventeenth Amendment. The applicability of this Circular to Foreign Venture Capital Investors (FVCI) is not clear and clarity is awaited on this point.
SEBI. On 14 July 2014, the RBI issued a circular allowing the issuance of warrants by Indian companies to foreign investors. The circular mandates the pricing of the warrants, a price conversion formula to be determined upfront and also 25% of the consideration amount to be received upfront. The balance consideration towards fully paid up equity shares must be received within a period of 18 months. The price at the time of conversion must not be lower than the fair value determined at the time of issuance of the warrants. Issuance of warrants is generally permitted, however the Indian company whose activity/sector falls under the government route will require prior approval of the FIPB, for issuing warrants under the automatic route. This regulation has opened the possibility for structuring PE investments through warrants. However, the feasibility of investing through such an instrument will need to be evaluated in the coming years.
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.
Certain rules that provide for monitoring of the GAAR were notified in 2013 and are to come into effect on 1 April 2016. However, in a recent budget announcement made on 28 February 2015, the government has proposed to modify GAAR by incorporating provisions of the Base Erosion and Profit Shifting' project of the Organisation of Economic Cooperation and Development. The timeline for applicability of GAAR has been extended to 1 April 2017. However, the necessary amendments and regulations are yet to be declared.
Benefits announced during the annual budget session
In the recent budget announcement made by the government on 28 February 2015, the government has taken note of the practical difficulties in seeking foreign investment into AIFs and VCFs, with such investments requiring scrutiny and approval of the FIPB. The government has clarified its intention to remove the approval requirement, so that foreign investments into AIFs/VCFs may increase investments in India, and will support the country's entrepreneurial ecosystem. However, the necessary amendments and regulations are yet to be declared. The government has also recognised the need for giving a "tax pass-through" status to both category I and category II AIFs. Therefore PE funds can now benefit from a tax pass through status, and not be subject to double taxation (in the hands of the fund, as well as the investor), as long as he is registered as a Category I or Category II AIF (see Question 5, 6 and 7).
SEBI notified the SEBI (Real Estate Investment Trust) Regulations 2014 in September 2014 (REIT Regulation), to enable real estate investment trusts (REITs) to operate in India. While the REIT Regulations were notified in September 2014 and was looked upon by the market as a welcome move to further strengthen investments in the real estate sector, there was no clarity on the taxation aspects of the REITs. In the recent announcement of the annual budget by the central government on 28 February 2015, the government has clarified that tax pass through status will be extended to REITs. This has evoked stronger enthusiasm for investments in REITs, both by PE investors as well as the realty market generally. The statutory amendments are yet to be made.
Tax incentive schemes
Various tax incentives apply to PE investments. Some important incentives include:
Domestic funds registered as a VCF under the VCF Regulations or as category I AIF under the SEBI Alternative Investment Funds Regulations 2012 (AIF Regulations) (see Question 11) have been granted certain tax exemptions (section 10(23FB), Income Tax Act 1961 (Income Tax Act)) and pass through status (section 115U, Income Tax Act).
Other than the category of funds discussed above, the tax treatment depends on the structure/corporate identity of the funds. If such funds are set up as a determinate (that is, if the beneficiaries and their individual shares are ascertainable in the trust deed) and non-discretionary trust, then a tax pass through status can be achieved. The government has proposed to provide a tax pass through status to all sub-categories of category I AIF as well as category II AIFs. However necessary amendments to the Income Tax Act are yet to be made.
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 on dividends distributed to their investors.
Shareholders are exempt from paying tax on the dividends.
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 as a VCF, category I AIF, or as a foreign venture capital investment (FVCI) with SEBI. Shareholders are exempt from paying tax on the dividends. The benefit is proposed to also be extended to category II AIFs in the future.
Tax exemptions in case of share premium amount received apply to a portfolio company that receives the amount from a VCF.
In case of domestic funds registered as a VCF under the VCF Regulations, the tax concessions are only available in respect of income which accrues to the VCF from investment in unlisted companies.
In case of a category I AIF, tax benefits apply if the AIF has been granted a certificate as a VCF under the AIF Regulations and if all the following applies:
At least two-thirds of its investible funds are invested in unlisted equity shares or equity linked instruments of a venture capital undertaking.
No investment has been made by such AIFs in an associate company.
Units of the trust are not listed on a recognised stock exchange.
The benefit of a tax pass through status is available to all investments by a VCF in a VC undertaking, except the following:
Non-banking financial companies.
Activities not permitted under the government's industrial policy.
Any other activity that 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 most commonly used vehicles for setting up PE funds in India are trusts. Trusts are preferred from a tax efficiency perspective. Certain PE funds (especially those registered as AIFs) are incorporated as companies, although given the tax at entity level (other than category 1 AIFs), such structures are rare.
The AIF Regulations maintain the earlier position under the SEBI Venture Capital Fund Regulations 1996 (VCF Regulations), and continue to permit domestic funds to be formed as a trust, company or LLP.
While the AIF Regulations permit an LLP as a fund structure, the Registrar of Companies overseeing the registration of LLPs does not permit LLPs to be used simply as “investing vehicles“. In view of this, both SEBI and the Registrar of Companies are discouraging use of the LLP for AIFs.
The following are the broad features of a trust and a company as common private equity vehicles in India.
A trust is created by a trust deed that identifies the:
Beneficiaries of the trust.
Property to be administered by the trustees.
Stamp duty and registration charges are payable on the trust deed, depending on the:
Initial settling amount.
Place of fund creation.
The trust deed must be registered with the jurisdictional sub-registrar (a revenue authority) and it takes about one or two weeks to establish a trust. The process of establishing a trust is fairly simple, inexpensive and quick.
There are three types of companies:
One person company (a company that can be incorporated with one shareholder but regulated as a private limited company in most aspects).
Incorporation of a company takes about three to four weeks.
Income earned by a trust is exempt from tax if earned by SEBI-registered VCFs. Similarly, a determinate (the beneficiaries and their individual shares are ascertainable in the trust deed) and non-discretionary trust also has tax pass through status.
Companies registered as a VCF under the VCF Regulations or as a category I AIF are exempt from entity level taxation. The income of such companies and/or funds will continue to be exempt if the undertaking in which its funds are invested, after the investment, is listed on the stock exchange.
Further, venture capital companies or funds are exempt from withholding tax in respect of income distributed to their investors. The provisions of the Income Tax Act regarding taxation on distributed profits (dividend), distributed income and deduction of tax at source do not apply to venture capital companies or funds.
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 are not commonly used. LLPs are not tax efficient structures, since 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. However certain deductions are permitted to an LLP under the Income Tax Act, as follows:
Interest paid to partners, provided such interest is authorised by the LLP agreement.
Any salary, bonus, commission, or remuneration to a partner will be allowed as a deduction if it is paid to a working partner who is an individual. The remuneration paid to the working partner must be authorised by the LLP agreement and the amount of remuneration must not exceed the prescribed limits.
Funds overseas are often set up as companies and LLPs. These structures are generally not tax efficient in India (see Question 7). Therefore, in India funds are primarily set up as determinate and non-discretionary trusts. However, the governance of a trust is carried out strictly in terms of the trust deed, which must be comprehensively drafted.
Some of the targeted objectives of private equity funds are as follows:
Higher returns. The main objective of PE funds is to maximise the return on investment. PE funds primarily aim to invest in companies operating in high growth sectors that create significant value for their investors, by seeking to accelerate the growth curve of their investee companies.
Diversification. PE funds typically prefer a diverse portfolio, and tend to invest in various businesses covering large companies, small and medium sized enterprises, and start-ups.
Social goals. Certain PE funds invest to achieve certain social goals. For example, International Finance Corporation (the private sector arm of the World Bank Group), Pragati Fund, Aavishkaar India Fund II, World Business Capital and Ennovent Impact Investment Holding all aim to create development in 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 five to seven years.
Fund regulation and licensing
While a promoter or principal of a VCF (registered as an AIF) does not require any licences, he is required to meet certain criteria prescribed by the AIF Regulations, including being a fit and proper person in the manner prescribed by the SEBI (Intermediaries) Regulation 2008. The suitability of a person to act as a sponsor of a fund needs to be established with SEBI at the application stage.
On 21 January 2013, the SEBI issued the SEBI (Investment Advisers) Regulations, aimed at regulating investment advisers (Adviser Regulations), under which advisers to domestic funds need to be registered with SEBI. The following persons are exempted from the registration requirement:
Insurance agents/brokers who offer investment advice solely in insurance products, who are registered with the Insurance Regulatory and Development Authority.
Pension advisers who offer investment advice solely on pension products, 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.
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.
The corporate entity (not an individual) must include the words "investment advisers" in its name. Similarly, individuals registered as investment advisers must use the term "Investment Advisers" in all their correspondence with their clients.
The Investment Adviser must inform the SEBI in writing about any material change in the information submitted, or if it is false/misleading.
Foreign entities seeking to register as an investment adviser must also state whether the entity has a subsidiary in India and, if so, whether the subsidiary has sought any registration under the Adviser Regulations.
The Investment Adviser must comply with the Adviser Regulations.
Fund managers who qualify as portfolio managers must register with SEBI.
This area has been affected by the AIF Regulations:
Before 2012, domestic PE funds were registered as domestic VCFs under the VCF Regulations.
With the coming into effect of the AIF Regulations in 2012, all new funds must be set up under the AIF Regulations. Existing PE funds registered with SEBI under the VCF Regulations continue to be governed by the VCF Regulations, until the end of the fund term or scheme.
Domestic PE funds are investment funds regulated by SEBI under the AIF Regulations.
Offshore PE funds are treated as non-resident investors for the purpose of investing in Indian companies.
If an offshore PE fund is registered as a Foreign Venture Capital Investor (FVCI) under the SEBI (Foreign Venture Capital Investors) Regulations 2000 (FVCI Regulations), it is entitled to invest under the FVCI route under the existing foreign exchange laws. Consequently, investments by a SEBI registered FVCI are entitled to certain benefits, such as non-application of the pricing guidelines to such investments.
The general conditions of an AIF are:
Each scheme of an AIF is required to have a capital of at least INR200 million.
The minimum investment in an AIF must be INR10 million. However, if employees or directors of the AIFs, or an employee or director of the manager of the AIF, are making the investment, the minimum investment is INR2.5 million.
The manager or sponsor of a category I and II AIF must maintain a continuing interest of the lower of either:
2.5% of the capital; or
INR50 million in the fund.
A category I AIF or schemes launched by the fund must have a minimum tenure of three years and must be closed-ended. The tenure must be specified upfront at the time of registration.
Funds must be invested in the AIF according to a private placement.
If an AIF is registered as an angel fund, the minimum investment of an angel investor is INR2.5 million (which can be accepted by the angel funds for a maximum period of three years).
VCFs registered under the VCF Regulations continue to be governed by them. The VCF Regulations also prescribe certain restrictions in relation to the investment in a VCF, including:
Minimum investments of INR500,000 (other than for the employees or principal officer or directors or trustees of the VCF, or employees of the fund manager or asset management company).
Firm commitment from the investors for a contribution of at least INR50 million before the start of operations by the VCF.
An AIF and VCF is restricted from soliciting or collecting contributions except by way of private placement.
The following PE funds are exempted from obtaining registration under the AIF Regulations:
VCFs registered under the VCF Regulations continue to be regulated by them, until the existing fund or a scheme managed by the fund is wound up. However, such funds are not allowed to launch new funds or increase their total committed funds, until they re-register under the AIF Regulations.
Existing funds that are not able to comply with registration under the AIF Regulations can apply to the SEBI for an exemption from strict compliance. SEBI has authority to examine such reasons and provide a fund with an exemption, on a case-by-case basis.
Existing PE funds not raising fresh commitments are not required to register under the AIF Regulations, subject to submitting information on their activities to SEBI.
Funds managed by securitisation/asset reconstruction companies which are registered with RBI.
Any pool of funds which is directly regulated by other regulators. For example, non-banking financial companies registered as investment companies.
In relation to foreign investment:
There are restrictions under the current FDI policy relating to investment in funds incorporated/registered in India (see Question 15). FVCIs are the only subset of foreign investors who are permitted to invest in SEBI registered VCFs.
Despite the introduction of the AIF Regulations, the corresponding RBI regulations governing foreign investment have not been amended to specifically allow investments in AIFs by FVCIs under the automatic route. Therefore, all foreign investment in AIFs, including by an FVCI, currently requires the prior approval of the FIPB.
The FIPB has in the past closely scrutinised applications for approval. However in our experience such approvals have been fairly forthcoming, provided the investment is otherwise compliant with foreign investment laws and money laundering laws.
In the recent budget announcement made by the central government, on 28 February 2015, the government has allowed foreign investment into AIFs/VCFs without the need for FIPB approval. However, the necessary amendments are yet to be made.
In relation to insurance companies:
Insurance companies registered with the Insurance Regulatory and Development Authority (IRDA) can invest in category I and II AIFs under the AIF Regulations.
An insurer can invest in a category II AIF, if the category II AIF invests at least 51% of its funds in infrastructure entities, small and medium sized (SME) entities, VC undertakings or social venture entities.
Insurers cannot invest in AIFs which have the nature of funds of funds, leverage funds and category III AIFs.
All investments by insurance companies are subject to exposure limits specified by the IRDA.
Category I AIFs (see Question 11) cannot invest in units of any other category of AIFs. Similarly, category II AIFs can only invest in category I, and are not allowed to invest in funds of funds in category III.
An AIF cannot have more than 1,000 investors if the AIF is formed through a vehicle other than a company. If the AIF is formed as a company, it must be in accordance with the Companies Act 1956 and the New Companies Act. However, angel funds cannot have more than 49 investors.
There are no restrictions on the basis of nationality, net worth or age of investors in a PE fund.
PE funds, whether registered as an AIF or as a VCF under the VCF Regulations, must comply with the limits on investment amount and period (see Question 11, Regulation).
In a company, the following documents govern the PE fund and the relationship between investors and the fund:
Articles of association.
Shareholders' agreement as entered into by the investors.
Private placement memorandums.
The trust deed, the contribution agreement and the placement memorandum govern the PE fund and the relationship between investors (beneficiaries) and the fund.
The company and trust documents set out above normally provide for the following key rights for investors:
Minimum commitment of each investor.
The fund's objectives and exposure limits that it can take in its portfolio companies.
The commitment period and the investment period of the fund.
No fault termination right for the majority or more of the investors.
The distribution mechanism of profits of the fund.
Financial controls over the expenses of the fund.
Appropriate non-compete obligations on managers/sponsors of the funds during the commitment period.
Indemnity protections for investors.
Corporate governance rights such as quorum and voting rights, and situations that lead to conflict of interest. The method to handle such conflicts is clearly spelt out.
Nominees of investors are included in the advisory committee and usually counted to achieve a quorum. Sometimes institutional investors are also provided a seat on the investment committees.
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/removal of the investment manager;
the winding up of the fund or the establishment of rival funds;
investments in excess of the exposure limits;
decisions in relation to appointment and removal of key managerial personnel.
Principal investors are also provided with certain co-invest rights in the portfolio company in addition to the fund, in certain circumstances.
Interests in portfolio companies
Most common form
PE funds usually subscribe to equity or equity-linked instruments such as compulsorily convertible preference shares (CCPS) or compulsorily convertible debentures (CCD). This is because the foreign exchange laws only permit subscription to equity shares, CCDs and CCPS under the automatic route.
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 generally ratchets cannot be incorporated in a simple equity deal.
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. In terms of the Companies Act, if dividends are not declared on CCPS for two consecutive years, then CCPS shareholders have the same voting rights as that of the equity shareholders.
Some of the other forms of instruments used by PE investors are optionally convertible debentures (OCDs), optionally convertible preference shares (OCPS) and warrants. The key features of these instruments are the following.
OCDs. These are debentures that may be redeemable as envisaged in the Act or convertible into the equity shares of a company as per the terms of the issue, at a price agreed at the time of the issuance:
The articles of association of a company should contain an enabling provision for the issue of debentures and the creation of security by the board.
The quantum of the issuance is now subject to a special resolution to be passed by the shareholders of the company at their general meeting.
RBI treats OCDs or partially convertible debentures as debt-like instruments that are outside the sectoral caps of FDI.
They are not seen as equity instruments and therefore investment in such instruments is governed by the External Commercial Borrowing (ECB) Regulations issued by the RBI.
Investment through OCDs is not preferred by a PE fund/VCF, since the ECB Regulations provide less flexibility in light of various restrictions, for example, the amount that can be borrowed, persons from whom the amount can be borrowed and restrictions on the end-use of the investment.
OCPS. Similar to OCDs, preference shares that are not compulsorily convertible into equity shares are construed as ECBs under the foreign exchange laws, and therefore need to conform to the ECB guidelines. All CCPS and OCPS must be compulsorily redeemable on the expiry of 20 years from the date of issuance. The New Companies Act seeks to make an exception for infrastructure companies.
Warrants. Warrants are in the nature of options, that is, instruments that entitle its holder to acquire a specific number of shares in a company at a pre-determined price by an agreed time. Certain mergers and acquisitions and private equity deals have been structured using such financial instruments. However, the issue of warrants to foreign PE funds have historically required the approval of FIPB, and therefore have not been a preferred instrument. The recent regulations permit allotment of warrants to foreign PE funds, subject to satisfaction of various conditions. The feasibility of warrants as a preferred instrument for investment will need to be further evaluated in the coming years.
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 and the regulations under it (FEMA), subjecting the subscription to stricter restrictions. Subscription to shares by an offshore investor must comply with the pricing guidelines prescribed by the foreign exchange laws. However, this restriction does not apply to SEBI registered FVCIs.
FVCIs can only subscribe to fully and compulsorily convertible instruments such as CCPSs and CCDs. There are no other restrictions on the allotment or transfer of shares. The government also specifies an FDI policy on a yearly basis, which restricts/prohibits investments in certain sectors by offshore investors.
The shareholders agreement may include the following restrictions on the transfer of securities:
Non-disposal and lock-in periods.
Right of first offer.
Right of first refusal.
Drag along rights.
Tag along rights
Call/ put options.
The above restrictions can be included in the articles of association by an amendment.
In relation to capital gains tax:
A 15% short term capital gain tax applies on the transfer of an equity share in a company or transfer of a unit of an equity oriented fund.
Non-residents and foreign companies are charged a 10% long term capital tax on income earned from the transfer of unlisted securities.
The income earned by Foreign Institutional Investors by way of short term capital gains from the transfer of securities is taxed at 30% (15%, in the above cases) and income by way of long term capital gains is taxed at 10%.
PE funds are exempted from paying withholding tax on dividends and distributed income under the Income Tax Act (see Question 5, Incentive schemes).
Buyouts are not common in India. There are a number of regulatory restrictions on buyouts in India, such as the takeover code in the context of listed companies, sectoral restrictions on FDI, and statutory regulations of minority squeeze outs. Buyouts in regulated sectors such as financial services, telecoms and broadcasting are further regulated, and typically require approvals from sectoral regulators.
Leveraged buy outs (LBOs) are not permitted, since domestic banks are restricted by the RBI from carrying out acquisition financing. However, RBI issued the "Framework for Revitalising Distressed Assets in the Economy" on 30 January 2014 (effective from April 2014) signifying its intention to allow leveraged buyouts through specialised entities that want to buy stressed companies supported by bank lending. However, the regulations enabling the leveraged buyout for the acquisition of stressed assets, is yet to be announced. Further, under the Companies Act, companies are prohibited from leveraging their assets to raise investments.
Buyouts are not common in India (see Question 16).
If a buyer intends to purchase a controlling stake in a listed company, it will trigger an open offer. Further, all listed companies must maintain a minimum public float of 25%, other than in limited circumstances.
In addition, due diligence in listed companies is governed by SEBI Insider Trading Regulations, and prohibits investors from acquiring buyout stakes on the basis of unpublished price sensitive information.
Takeover bids are regulated by the SEBI Takeover Regulations and SEBI closely scrutinises and must pre-approve all open offers. This restricts the ability of investors to buyout a listed company.
As in all PE transactions, the principal documents governing a buyout are the share purchase agreement and the shareholders' agreement. If the buyout is by way of a bid process, the principal documents will also include bid documents. In case of buyouts of listed companies, a letter of offer, escrow agreements and other undertakings may also be required.
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 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 a tax indemnity is, in practice, rarely less than seven financial years after 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 is not treated as binding, either on the shareholders or on the company.
PE funds typically enjoy anti-dilution protection. The protection can either be in the nature of a full-ratchet protection or weighted-average. In some instances these rights are a combination of the two. The enforceability challenges are higher with a foreign PE fund as opposed to a domestic PE fund having such a right. However, if the investment is made by the offshore PE fund by way of CCPS or CCD, as its instrument, implementation becomes less complicated.
A variety of covenants can be included to correct any irregularities in the business or operations, including non-solicitation and non-compete clauses limited by time and geographical limits.
Several investors have in the past negotiated exit rights/put option rights as protection against defaults. These put options are linked to a price that generates an IRR for the investor. Put options providing assured returns (that is, linked to IRRs) are not allowed for foreign investors, and can only be permitted by RBI at the prevailing market price (see Question 4). This is in addition to other exit protection rights such as rights to:
Drag along the promoters.
Cause the company to go public.
Cause a sale of the company.
Realise investments from the proceeds.
Buyouts are not common (see Question 16). The nature of protection sought by the PE fund in a buyout is 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.
Under the SEBI Takeover Regulations, directors of a company are required to scrutinise and recommend whether a takeover is in the interest of the company. Further, in management buyouts, the primary duty of the directors is owed to the company (fiduciary duties). Therefore any contractual commitment made by any director to an investor, if in breach of his fiduciary duties, is void.
Duties and liability for breach of them apply to directors under the New Companies Act (see Question 4).
Further, directors are also under an obligation to not disclose unpublished price sensitive information to investors. This duty previously only applied to directors of listed companies under the SEBI Insider Trading Regulations. Under the New Companies Act, it has been extended to unlisted companies.
In addition, employment agreements of executive directors typically include confidentiality and non-solicitation obligations, as well as an obligation to devote all his time and efforts to the business and progress of the company.
Management buyouts are not common (see Question 16). Typical terms of employment imposed in a PE transaction include:
Non-competition and non-solicitation restrictions.
Performance linked incentives.
Obligation to spend substantial time on the business and to not take up any other office of profit.
Grant of stock options.
Assignment of intellectual property.
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. The debt to equity ratio typically ranges between 60:40 and 70:30. 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 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 and non-disposal undertakings.
Mortgage of the company's assets (mortgage of land is very common in real estate transactions).
Contractual and structural mechanisms
Creditors normally impose various restrictions on the company, including on:
Payment of dividends or any monies to shareholders.
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 and shareholding structure.
Change of control, including any change of the board's structure.
Borrowing money or making any debt commitments.
Disposing or creating an encumbrance over any of the company's assets.
Change in business
Change in business plan.
Modification of any charter/constitutional documents of the company.
Providing guarantees on behalf of any other person.
Merger, consolidation, reorganisation or amalgamation
Most loan documents include a condition that any future or other debts incurred by the company will not rank as superior to the loan being granted by the creditor.
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 on a pari passu basis. 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 creditors.
Domestic debt holders can achieve equity appreciation through conversion features such as rights, warrants or options or conversion rights under the loan agreement. Banks registered with the RBI are only permitted to hold up to 30% of the share capital of a company. However this limit does not apply in case of conversion of the loan under an event of default.
ECB lenders are also permitted to convert debt into equity subject to meeting certain conditions specified by RBI (such as the debt must be converted into equity as per the pricing guidelines of the RBI, and the exchange rate applicable for the ECB must be the rate prevailing on the date of the agreement between the parties concerned for such conversion).
Foreign investors can only invest in CCPS or CCDs (see Question 15, Restrictions). Any agreement among the parties for conversion features such as rights, warrants or options is subject to pricing guidelines and other regulations under FEMA.
Under the Companies Act, the conversion must occur at a price equal to or more than the face value/par value of the shares.
Portfolio company management
The existing Indian anti-corruption/anti-bribery law (the Prevention of Corruption Act 1988 (PCA)) criminalises the receipt of illegal gratification by public servants and the payment of illegal gratification by a person to a public servant.
The PCA currently does not deal with private-sector bribery. While a new anti-corruption bill criminalising private-sector bribery is currently awaiting approval by the Indian parliament, various PE funds typically seek recourse under the US Foreign Corrupt Practices Act 1977 (FCPA) and UK Bribery Act 2010 (UKBA), in cross-border transactions. Given the far reach of global bribery laws, various Indian companies are reconsidering their existing process and procedures, to minimise the bribery risk under the FCPA and the UKBA.
Typically, PE funds insist on receiving representations and warranties in relation to compliance with anti-bribery/anti-corruption laws, including the FCPA and UKBA. Breach of such 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.
PE investors also insist on extensive covenants by the promoters and the company, to ensure compliance with the anti-corruption/anti-bribery laws. Typically, annual compliance certificates are required.
If a fund's executive is involved in offering bribes to a public official, he is liable for criminal prosecution under the PCA, and can be imprisoned for a period ranging from six months to five years. The PCA does not stipulate a specific provision relating to offences by companies. However, it has been held in various decisions that a corporation can be prosecuted for an offence under the PCA, and fined and convicted for an offence under the PCA. In this context, a director (including a PE fund's executive who is a director) who had knowledge of the offence and neglected to take steps to prevent its commission may be liable.
Forms of exit
The most common forms of exit are put options and strategic sale. Some investors also negotiate an exit by way of an initial public offer (IPO). Drag along, buy-back or sale to the promoters are also typically set out in investment agreements. Although the PE funds may have significant control over the portfolio company, they may require the co-operation of shareholders to execute their exit strategies.
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. Further, in the current economic climate, India has seen very few IPOs. SEBI has also introduced rules to incentivise IPOs for small and medium enterprises.
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 strategic buyers, buybacks and put options are the most commonly used forms of exit in an unsuccessful/distressed company.
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 regulatory uncertainty that surrounded the legality of put options has been put to rest by SEBI and RBI (see Question 4), whether put options will be used extensively (in light of the restrictions on them) is unclear.
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.
Reserve Bank of India
Description. The official website of the Reserve Bank of India (RBI), the foreign exchange regulator. The website is in English and updated regularly. It includes RBI policy documents and official reports.
Securities and Exchange Board of India (SEBI)
Description. The official website of India's securities regulator, the Securities and Exchange Board of India (SEBI). The website is in English and updated regularly. It includes securities related legislation.
Indian Department of Industrial Policy and Promotion (DIPP)
Description. The official website of the Department of Industrial Policy and Promotion (DIPP), the department overseeing industrial policy in India. The website is in English and updated regularly. It includes industry and policy related documents.
Indian Income Tax Department
Description. The official website of the Department of Income Tax in India. The website is in English and updated regularly. It includes tax related legislation.
Siddharth Raja, Partner
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 (Foreign and Commonwealth Office Chevening Scholar and a JN Tata Scholar).
Areas of practice. Private equity and venture capital investments; cross-border and domestic M&A corporate finance and general commercial law.
- Acted for Helion Venture Partners III LLC in connection with the first round of investment in ID Fresh Food (India) Private Limited.
- Acted for Aquarius Investment Advisors Pte Ltd, a private equity and venture capital firm with respect to the investment in Vaatsalya Healthcare Solutions Pvt Ltd.
- Acted for Ascent Capital, in relation to an investment of INR 35 crores in Supermarket Grocery Supplies Private Limited and another investment in i-Nurture Education Solutions Private Limited.
- Acted for Urban Ladder, in relation to an investment by IndoUS Venture Partners.
- Acted for VTS-Poland, in relation to its Indian joint venture and subsequent buy-out of its partner.
- Acted for Aureos Capital in its investment of US$10 million in BSR Super Specialty Hospitals Limited, and a follow-on round of investment.
- Acted for Omnesys Technologies, in the acquisition of equity stake by Intel Capital and subsequently, with an acquisition of a majority stake in Harsa IT Solutions Private Limited.
- Acted for IDG Ventures India’s investments in Manthan Systems, iViZ Techno Solutions, Aujas Networks, Myntra Designs, iCreate Software and Yatra.com.
Languages. English, Hindi
Ashwini Vittalachar, Partner
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, USA (2007)
Areas of practice. Private equity and venture capital transactions; cross border and domestic acquisitions; joint ventures; employment law; general corporate and regulatory advisory matters.
Acted for SSN Logistics Private Limited (Delhivery), a Gurgaon based company providing logistics solutions and allied services to various E-commerce ventures, with respect to an investment by Multiples Private Equity Fund I Limited and Multiples Private Equity Fund, leading venture capital funds investing in high growth mid-sized Indian companies; Nexus Ventures III, Ltd. and Times Internet Ltd..
Acted for Etechaces Marketing & Consulting Private Limited (PolicyBazaar), in connection with private equity investments from Tiger Global and Premji Invest, as well as in connection with certain general corporate/employment law matters.
Acted for Manpower Group, a global leader in workforce solutions, in respect of its various acquisitions in Australia-New Zealand (ANZ) region.
Acted for promoters of various start-up companies in connection with seed investments by India focused venture funds.
Acted for Altran Technologies India Private Limited, in connection with acquisition its various acquisitions, including the business of Kavya Projects Private Limited.
Acted for Aquarius Investments, an India-centric overseas fund investing in mid-sized companies, with respect to an investment in Vaatsalya Healthcare Solutions, a Bangalore-based company that operates primary and secondary healthcare centres in semi-urban and rural areas.
Acted for iProf Learning Solutions Limited and its promoter, a Noida based digital education company and a tablet-based education provider, in respect of the Series B investment by Hobsons, IDG Ventures India and Norwest Venture Partner.
Acted for a world-renowned German medical products and healthcare services corporation, with respect to establishment of dialysis clinics through its New Delhi-based Indian subsidiary.
Languages. English, Hindi, Kannada