Guidelines issued by the Reserve Bank of India (RBI) restrict an Indian bank’s ability to finance the acquisition of equity shares. Generally, a promoter’s contribution towards equity cannot be funded by a bank and banks cannot finance the acquisition of equity shares, other than in exceptional cases. Therefore, financing for a domestic acquisition is generally procured from non-banking financial companies (NBFCs) or by issuance of non-convertible debentures (NCDs) by the acquirer which can be subscribed to by foreign portfolio investors (FPIs), mutual funds and alternate investment funds (AIFs).
NBFCs are registered with the RBI and enjoy a more relaxed regulatory framework compared to banks. International banks often lend through their offices outside India to borrowers based outside India for the purposes of acquisitions in India, or they lend to Indian borrowers for Indian acquisitions through the FPI route (discussed in 1.2 Corporates and LBOs and 3.1 Senior Loans).
In the Indian context, cross-border acquisitions are commonly classified in two categories.
For an inbound acquisition where the acquisition is through an offshore acquirer, the lending market essentially comprises international banks, capital markets, financial institutions and offshore debt funds. However, such acquisition finance cannot be secured by a pledge on shares of the Indian target, charge on assets of the Indian target or guarantees from the Indian target due to Indian exchange control regulations. Additionally, Indian banks, Indian financial institutions and domestic funds cannot provide finance to an offshore entity to acquire shares of an Indian company.
For an acquisition by an FOCC, finance cannot be provided by Indian banks, Indian financial institutions or domestic funds, as FOCCs are not permitted to leverage in the Indian market for the acquisition of shares. An Indian company can raise foreign currency financing from offshore lenders in the form of external commercial borrowings (ECB), but these cannot be used for equity investments in India. The primary source of debt funding which an FOCC can avail for acquisition of an Indian target is through the issuance of NCDs which can be subscribed to by FPIs. FPIs are registered with the Securities and Exchange Board of India (SEBI) under the SEBI (Foreign Portfolio Investors) Regulations, 2019 (FPI Regulations).
For an outbound acquisition, an Indian acquirer can borrow domestically from banks, financial institutions and other lenders if it complies with certain qualitative and quantitative restrictions. Additionally, if the acquisition of the offshore target is through an Offshore SPV, the Offshore SPV can borrow funds offshore from offshore lenders, funds, capital markets and other financial institutions. Further, ECB can also be raised by an Indian company from overseas lenders and other recognised lenders for acquisition of an overseas target. Creation of security and providing guarantees is also permitted, subject to certain conditions.
Additionally, the Insolvency and Bankruptcy Code, 2016 (IBC) has also opened up a new avenue of acquisition of Indian distressed companies through a statutory process. Such acquisitions domestically, in certain cases, have been leveraged buyouts.
The RBI has also introduced the Prudential Framework for Resolution of Stressed Assets on 7 June 2019, which requires banks to resolve a stressed asset in a time-bound manner and may involve resolution by way of a change of ownership of the borrower. Some leveraged buyouts can be expected in such restructurings.
At the onset of COVID-19 in April 2020, the Government of India issued press note 3 of 2020 (Press Note 3) and the Foreign Exchange Management (Non-debt Instruments) Amendment Rules, 2020 (NDI Amendment Rules) amending certain rules for foreign direct investments from neighbouring countries. These amendments provide that any foreign direct investment:
requires approval from the Government of India. Press Note 3 and the NDI Amendment Rules do not prescribe any specific threshold in relation to the term “owner” or “beneficial owner” and, accordingly, no specific threshold is prescribed for investment by an entity (whether direct or indirect) from a neighbouring country.
The Press Note 3 and the NDI Amendment Rules have affected new and proposed foreign direct investments from neighbouring countries and consequently, any financing thereof.
The market has swiftly adjusted to limitations posed by COVID-19 and the lockdowns in India. Some initial hiccups were faced with the electronic signing of documents and making stamp duty payments (which are required to be made before the execution of documents). However, Indian lenders, who are accustomed to physical signings, adapted to using digital signatures or working on the basis of scanned documents (which would be followed up with wet ink signatures). Also, once the lockdown was eased, procuring stamp papers became easier. Certain timelines for registration of documents and obtaining approvals were relaxed due to the COVID-19 pandemic. Lenders (and their counsel) have begun to factor some of these practical issues into the deal timelines and also to plan for these in advance to prevent execution bottlenecks.
Financing documents for acquisition finance raised by an offshore borrower are typically governed by English law.
Financing documents for acquisition finance raised by an Indian borrower domestically are governed by Indian law. Transaction documents in relation to NCD issuance by an Indian company are also governed by Indian law.
Security and guarantee documents are generally governed by the law of the jurisdiction where the assets are located or the jurisdiction of which the guarantors are nationals or in which they are incorporated.
The choice of foreign law to govern an agreement is generally upheld by Indian courts, unless, in the view of the Indian courts, the choice of foreign law is not bona fide or if the application of foreign law is opposed to the public policy of India. In any proceedings in India, foreign law has to be proved as a matter of fact by leading expert evidence of foreign legal counsel.
In any acquisition financing where the funding is in a foreign currency and obtained from foreign lenders, the credit agreements and intercreditor agreements will generally be based on the latest Asia Pacific Loan Market Association (APLMA) or Loan Market Association (LMA) forms.
For acquisition financings in Indian rupees (INR) where the lenders are Indian NBFCs, funds or FPIs, the nature of documentation varies with every transaction and there is no industry-accepted market standard. Some banks and NBFCs may have their own formats of facility agreements or debenture documents.
In relation to the issue of NCDs, the Companies Act, 2013 (Companies Act), and its related rules, prescribe some prerequisites for the debenture trust deed. The debenture trust deeds are also governed by various SEBI regulations if the NCDs are listed on a stock exchange. In addition, the information memorandum or the offering memorandum for NCDs must be in a format as prescribed by the Companies Act and applicable SEBI regulations.
There is no market-accepted form of documentation for security documents in relation to assets located in India.
There are no specific legal requirements as to the language in which documentation for acquisition financing is to be drafted. However, all finance documents for acquisition financings, security and guarantee are in the English language.
Where a finance document is executed by an Indian company, resident or national, standard capacity, authority and enforceability legal opinions are issued. The opinions are issued on the basis of the conditions-precedent documents provided by the borrower/obligors.
Inbound Acquisition Finance: Offshore Acquirer
Typically, the offshore acquirer sets up a special-purpose vehicle outside India (FDI SPV) which acquires shares of an Indian target by way of foreign direct investment (FDI) into India. The FDI SPV raises debt from offshore lenders in the form of senior loans to finance the acquisition. Such loans are secured by all the assets and shares of the FDI SPV (other than the shares of the Indian target and any other Indian asset).
Given that there are restrictions under Indian exchange control laws on pledging shares of an Indian target to secure acquisition finance availed by the FDI SPV, generally a non-disposal undertaking is obtained in relation to the Indian target shares held by the acquirer, coupled with a pledge on the acquirer shares.
If the Indian target is a listed company and the FDI SPV holds (together with persons acting in concert) 25% or more shares or voting rights in the target, or controls the target, then any enforcement of the pledge on the shares of the FDI SPV may trigger a mandatory open-offer requirement under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Regulations). A mandatory open offer must be made for at least 26% of the voting shares of the target.
In the case of a sponsor financing, the financing may also benefit from an equity commitment letter from the sponsor.
Inbound Acquisition Finance: FOCC
As mentioned previously, an FOCC cannot avail acquisition finance from Indian banks, financial institutions or Indian funds, as FOCCs are not permitted to leverage in the Indian market for acquisition of shares. If the acquisition is through an FOCC, the debt can be raised by the FOCC by issuance of NCDs which are subscribed to by FPIs. NCDs are structured as senior debt and are secured by all the assets of the FOCC and a pledge on the shares of the target. Further, if the target is a private limited company, security can also be created on the assets of the target to secure the acquisition finance. However, such security may need to be shared with the other lenders of the FOCC and the target.
Outbound Acquisition Finance
For an outbound acquisition made directly by an Indian acquirer, the following financing structures are typically adopted.
Domestic Acquisition Finance
Domestic acquisition finance is generally structured as NCDs or loans from NBFCs.
The proceeds of NCDs issued on a private placement basis can be used for equity investments. However, the proceeds of unlisted NCDs cannot be used for capital market investments. Further, the proceeds of a public issue of listed NCDs cannot be used for the acquisition of shares of any person who is part of the same group or who is under the same management.
Generally, NCDs are required to have a minimum maturity or duration of one year at the time of investment by the FPI. Any investment by an FPI in NCDs will need to comply with the concentration limits and single or group investor wise limit prescribed by the RBI. It should be noted that:
The RBI has also provided for a separate channel, called the Voluntary Retention Route (VRR), to enable FPIs to invest in NCDs. The investments through the VRR are free of the macro-prudential and other regulatory norms applicable to FPI investments in debt markets, provided FPIs voluntarily commit to retain a required minimum percentage of their investments in India for a specified period. If the FPI is investing in the NCDs under the VRR, minimum average maturity, single-borrower limits and concentration norms do not apply to those NCD investments.
Further, NCDs are required to have a minimum maturity of 90 days. However, if NCDs are issued with a maturity of less than one year, they are regulated by guidelines issued by the RBI in this regard (RBI NCD Guidelines). The RBI NCD Guidelines prescribe stringent guidelines for such issuances, including a minimum rating requirement of "A2" as per rating symbol and definition prescribed by the SEBI and specific eligibility requirement for the issuer.
The NCD route offers greater flexibility on payment of interest to NCD holders, as there are no interest rate caps for privately placed NCDs.
Further, under the ECB Guidelines, eligible borrowers who are participating in the corporate insolvency resolution process (CIRP) under IBC as resolution applicants can raise ECB from all recognised lenders, except foreign branches or subsidiaries of Indian banks, for repayment of rupee term loans of the target company with the prior approval of the RBI.
While payment-in-kind (PIK) loans are not very popular in the Indian scenario, where the borrower is an Indian acquirer, PIK loans are generally structured by way of NCDs. Loans from NBFCs can also be in the form of a PIK loan. Since the RBI requires banks to charge interest on a monthly basis, Indian banks cannot extend PIK loans. However, there have been PIK structures where the borrower is an entity incorporated outside India.
Mezzanine finance is generally raised in the form of compulsorily convertible preference shares, optionally or partially convertible preference shares, compulsorily convertible debentures or optionally or partially convertible debentures. However, if the mezzanine finance is provided by an offshore entity, optionally or partially convertible preference shares or optionally convertible debentures are treated as ECB and will need to comply with the ECB Guidelines.
Bridge loans for acquisition finance are need-based and are raised pending the tie-up of the final financing for the acquisition. These bridge loans for acquisition finance are generally availed from NBFCs. ECB cannot be structured as bridge loans due to their minimum average maturity period requirement. Further, NCDs with a maturity period of less than one year are subject to conditions set out under the RBI NCD Guidelines and are not prevalent.
ECB can be raised from abroad by issuing bonds. Such bonds can be either listed or unlisted. Given that such bonds are required to comply with the all-in cost ceilings under the ECB Guidelines, such bonds are generally not high yield.
Domestically, bonds are issued as NCDs. Where the issuers are not investment grade, the NCDs can be high-yield bonds as there is no interest cap in relation to the NCDs.
The return on the NCDs can also be linked to the returns on other underlying securities/indices. However, such NCDs must be compliant with the structured product guidelines issued by the SEBI.
ECB issued as bonds can be privately placed with the eligible lenders outside India.
An offer or invitation to subscribe to privately placed NCDs can be made to no more than two hundred persons on aggregate in a financial year. Unlisted NCDs need to comply with the Companies Act. Further, if the bonds are listed on a recognised stock exchange in India, their issuance should follow the guidelines issued by the SEBI in this regard, in addition to the Companies Act.
As discussed in 5. Security, security is permitted to be created (to the extent discussed therein) for various financings that may be availed for funding acquisitions. Acquisition finance (as discussed throughout 3. Structures) can also be asset-backed. The borrower in such structures is usually required to maintain a certain loan-to-value (LTV) ratio or security cover ratio.
Intercreditor agreements are common in the Indian market where security is shared between multiple lenders. The intercreditor agreements provide for arrangements between various classes of creditors. Generally, the borrower is not a party to the intercreditor agreement. However, it executes an acknowledgement to the intercreditor agreement.
Intercreditor agreements, inter alia, govern the following:
In relation to ECB and acquisition financing, where the acquirer is an Overseas SPV or an FDI SPV and the funding is obtained from foreign lenders, the intercreditor agreements will generally be based on the latest APLMA or LMA forms.
In liquidation of the borrower, an intercreditor agreement between lenders setting out equal ranking, which disrupts the order of priority set out under the IBC, is not required to be considered by the liquidator.
The SEBI has issued a circular which governs the process to be followed by debenture trustees of listed NCDs for enforcement of security and execution of intercreditor agreements.
The approach remains the same as previously set out. If the security is to be shared between the lenders of the borrower and the bondholders, similar intercreditor agreements must be entered into.
If the hedges obtained by the borrower are secured with the assets on which other lenders also have security, the hedge counterparties are also parties to the intercreditor agreements. The rights of the hedge counterparty under the intercreditor agreements are synonymous with the ranking of its security.
Security on the assets of an Indian entity and shares of an Indian company is usually created in the following manner:
Security over immovable property such as land and buildings is created in the form of a mortgage. The Transfer of Property Act, 1882 (TOP Act) primarily governs the creation of mortgages. The common forms of mortgage are an English mortgage (a registered mortgage) and an equitable mortgage (a mortgage created by depositing the title deeds with the lender or security trustee).
The TOP Act provides that a mortgage (other than an equitable mortgage) for repayment of money exceeding INR100 must be created by way of a registered instrument. The instrument creating the mortgage is required to be signed by the mortgagor and registered with the land registry where the mortgaged immovable property is situated.
For an equitable mortgage, the authorised representative of the mortgagor deposits the title deeds in relation to the immovable property with the lender or security trustee with an intention to create a mortgage, and provides a declaration at the time of the deposit. The lender or security trustee records the deposit of title deeds by way of a memorandum of entry. In some states, an equitable mortgage needs to be registered or notified to the land registry.
Shares and other Securities
Security over shares and other securities is typically created by way of a pledge. A pledge agreement or deed is entered into between the pledgor and the pledgee to create and record the pledge. A separate power of attorney is also issued by the pledgor in favour of the pledgee that allows the pledgee to deal with the pledged shares/securities in the case of an event of default and take other actions on behalf of the pledgor.
Movable property, such as receivables, plant and machinery, accounts and stock, is usually secured by way of hypothecation. Under Indian law, hypothecation generally means a charge over any movable property. The charge created by way of hypothecation may be a fixed charge over identifiable assets or fixed assets and is usually a floating charge over current assets and stock-in-trade.
The security-provider executes a deed of hypothecation in favour of the lender or security trustee.
India is an exchange-controlled economy and creation of security on the assets of an Indian company in favour of persons outside India or assets of a non-resident Indian in India is governed by the Foreign Exchange Management Act, 1999 (FEMA) and rules and regulations are framed thereunder. Any cross-border security or guarantee is governed by the FEMA. The security that can be created for the various acquisition finance structures is discussed below.
Inbound Acquisition Finance: Offshore Acquirer
Any acquisition financing availed by an offshore acquirer for the purpose of acquiring the shares of an Indian company cannot be secured by a pledge on the shares acquired by the offshore acquirer without the prior approval of the RBI.
Further, no security can be created on the Indian assets of the target or any other person resident in India for securing any such acquisition finance.
Inbound Acquisition Finance: FOCC
As the acquisition finance availed by an FOCC by way of NCDs is domestic debt, this debt can be secured by Indian assets of the FOCC. Security on Indian assets of the target will be subject to financial assistance rules. However, prior approval of the RBI is required for creation of pledge on the shares of the FOCC held by the non-resident shareholder to secure the NCDs.
Outbound Acquisition Finance
The following security can be created in the case of an outbound acquisition finance, subject to the Indian entity complying with the conditions and other qualitative and quantitative restrictions set out under Overseas Direct Investment (ODI) Guidelines after obtaining the approval of the authorised dealer bank (ie, banks in India that have been given special licences to deal with foreign exchange):
The value of the facility is assessed as a financial commitment for the Indian party and the total financial commitment of the Indian party should be within the limits set out in the ODI Guidelines. Currently, this limit is 400% of the net worth of the Indian acquirer, which should not exceed USD1 billion in one financial year.
In the case of ECB, the RBI has permitted authorised dealers to grant permission in relation to the creation of security over movable property, immovable property and financial securities in favour of or for the benefit of an ECB lender.
Domestic Acquisition Finance
Acquisition finance by an Indian entity by way of NCDs or loans from NBFCs is domestic debt and this debt can be secured by Indian assets of the acquirer and the Indian group companies of the acquirer.
The acquisition finance availed by an Indian acquirer from Indian banks or financial institutions for an outbound acquisition can be secured by security on the Indian assets of the acquirer or the Indian group companies of the acquirer.
Generally, the following perfection requirements exist in relation to the security created on the assets of an Indian company:
See 5.2 Form Requirements for various security perfection and registration requirements. Further, any security created under the ODI Guidelines will also need to be reported to the RBI through the authorised dealer bank in the form prescribed under the ODI Guidelines.
Generally, upstream security can be provided by an Indian company for the indebtedness of its Indian holding company, subject to compliance with the provisions of the Companies Act. See the discussion in 5.6 Other Restrictions in relation to shareholder resolutions and common directors that will need to be complied with for creation of any such security. The creation of upstream security by an Indian company for financing availed by an offshore holding company is restricted under the FEMA.
However, upstream security on the assets of the target (which is not a private company) may not be possible for a debt used to acquire the shares of the target. See the discussion in 5.5 Financial Assistance.
As per the Companies Act, a public company (whether listed or not) is prohibited from providing any direct or indirect financial assistance to any person for subscription to, or for the purchase of, its own shares or the shares of its holding company. The term "financial assistance" is broad and includes assistance in the form of loans, guarantees and the provision of security. This restriction does not apply to a private company.
In view of the foregoing, a target company that is a public company cannot create security or provide guarantees in relation to acquisition finance availed for acquisition of its shares.
Shareholders’ approval by way of special resolution (75%) is required under the Companies Act for an Indian company to provide any guarantee or security if certain prescribed thresholds (in terms of paid-up capital and free reserves) are exceeded. However, this approval is not required if the guarantee or security is being provided for a financing utilised by the company’s wholly owned subsidiary or joint venture.
As per the Companies Act, a company (lending company) cannot give loans, provide security or extend any guarantee to or on behalf of any other company in which the directors of the lending company are interested or control a certain percentage of voting rights unless such a loan, guarantee or security falls within the exemptions prescribed under the Companies Act. Certain relevant exceptions to this rule are:
Generally, a lender may enforce its security on the occurrence of an event of default. The process to be followed for enforcement of the security is briefly set out below.
If the mortgage is an English mortgage, the mortgagee has the power to sell the mortgaged property without the intervention of the court, subject to certain notification requirements. Where the mortgage is an equitable mortgage, the mortgagor must apply to the court for a decree to sell the mortgaged property in order to recover the debt.
Indian banks, certain notified financial institutions and debenture trustees for listed and secured NCDs can enforce a mortgage under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), which provides for a quicker mode of enforcement of security.
The rights and remedies of a hypothecatee are entirely regulated by the terms of the deed of hypothecation between the hypothecator (security-provider) and hypothecatee (the lender). A deed of hypothecation can be enforced either by appointing a receiver and selling the charged assets or by obtaining a decree for sale of the movable property. Indian banks, certain notified financial institutions and debenture trustees for listed and secured NCDs can enforce hypothecation under the SARFAESI, which provides for a quicker mode of enforcement of security.
Pledge over Shares
A pledgee may enforce a pledge by giving reasonable notice of enforcement to the pledgor. The pledgee does not need to obtain a court order to sell the pledged shares. If the pledged shares are held in physical form, the pledgee must submit to the company whose shares are pledged the executed share transfer forms held by the pledgee. The company will then need to approve the transfer of shares in the name of the lender or third-party transferee at its board meeting. If the company refuses to approve the transfer of shares, the lender or third-party transferee will need to approach the competent courts and tribunals to challenge that refusal.
If a company is admitted to the Corporate Insolvency Resolution Procedure (CIRP) under the IBC or a pre-packaged insolvency resolution process commences against a company under the IBC, no security can be enforced, due to the moratorium imposed under the IBC. Where the company is to be liquidated under the IBC, a secured creditor will have an option to realise its security and receive proceeds from the sale of the secured assets as first priority. Additionally, in the case of any shortfall in recovery, the secured creditors will rank junior to the unsecured creditors to the extent of the shortfall.
Generally, a guarantee is obtained from the holding or group company of the acquirer or the target (where financial assistance rules are not attracted).
If the guarantee is issued by a non-resident entity for an NCD, that guarantee will need to comply with the following key conditions:
Indian entities cannot provide guarantees for the obligations of their overseas parent company.
An ECB can be guaranteed upon obtaining a no-objection from an authorised dealer, as per the ECB Guidelines. If the guarantee is issued by a non-resident entity, the guarantor is required to fulfil the qualification of a recognised lender under the ECB Guidelines.
Under the ODI Guidelines, an Indian company which holds shares in an Offshore SPV (Indian Party), can provide a guarantee or procure a guarantee from indirect resident individual promoters of that Indian Party, the promoter company, group company, sister concern or associate company of the Indian Party, subject to certain qualitative and quantitative requirements specified in the ODI Guidelines, including the following:
See also 5.6 Other Restrictions in relation to the restrictions under the Companies Act for issuance of guarantees.
See 5.6 Other Restrictions in relation to the restrictions under the Companies Act for issuance of guarantees.
It is not mandatory under Indian law for the borrower to pay a guarantee fee to the guarantor. Prior approval of the RBI may be required for payment of any guarantee fees by a person in India to a person outside India in relation to a guarantee issued by that person for an INR loan.
The IBC provides for a payment waterfall for the creditors in the event of the liquidation of a company. The priority waterfall for distribution of liquidation proceeds, prescribed under the IBC, is as follows:
The National Company Law Tribunal (NCLT), in one of the cases under the CIRP, has also held that the unsecured intra-group debt from a related party should be treated as an equity contribution rather than an intra-group loan. These intra-group loans should rank lower in priority than the same obligations between unrelated parties. Further, in one of the judgments, the National Company Law Appellate Tribunal has also held that promoters or shareholders cannot claim to have been discriminated against if no amount is given to the promoters or shareholders while the other equity shareholders of a corporate debtor who are not the promoters have been separately treated and have been provided certain amounts under the resolution plan.
The different preference periods or reasons for claw-back during insolvency or the CIRP of an Indian company are set out as follows.
Under the IBC, a corporate debtor shall be deemed to have been given preference if:
However, the following are not considered as preferential transactions:
The claw-back period in relation to a related party (other than being an employee) is two years preceding the insolvency commencement date (ICD) and for a non-related party is one year preceding the ICD.
A transaction (other than a transaction in the ordinary course of business of the corporate debtor) is considered undervalued where the corporate debtor makes a gift to a person or enters into a transaction with a person that involves the transfer of one or more assets by the corporate debtor for a consideration, the value of which is significantly less than the value of the consideration provided by the corporate debtor.
However, the following transactions are not considered undervalued:
The claw-back period in relation to a related party is two years preceding the ICD and for a non-related party one year preceding the ICD.
Undervalued Transaction Defrauding Creditors
An undervalued transaction (as previously discussed) entered into by a corporate debtor is considered to be entered into for defrauding the creditor if the NCLT is satisfied that the transaction was deliberately entered into by that corporate debtor for keeping the assets of the corporate debtor away from any person entitled to make a claim against the corporate debtor; or to affect adversely the interest of that person in relation to the claim.
No specific claw-back period is specified for such transactions.
Extortionate Credit Transaction
Extortionate credit transactions are transactions where the corporate debtor is a party to a transaction involving the receipt of financial or operational debt during the period within two years preceding the ICD and where the terms of the transaction:
However, any debt extended by any person providing financial services which is in compliance with the law is not considered as an extortionate credit transaction.
Stamp duty is required to be paid on a facility agreement and security documents at or prior to execution. An insufficiently stamped document is not admissible as evidence in a court of law. Stamp duty differs from state to state and is determined based on the nature of the document.
Currently, the applicable rate of withholding tax on interest payable by an Indian company to a non-resident lender (situated outside India) on ECB and Rupee Denominated Bonds is 5% (plus applicable surcharge and cess), subject to the satisfaction of certain conditions and provision of prescribed documents. This tax is withheld from the interest payable to the lender and deposited on the lender’s behalf with the government. The tax withholding rate of 5% is not applicable if the lender is the branch of a foreign bank located in India.
Foreign banks which have a branch in India have the option of applying for and obtaining a certificate allowing the borrower to deduct tax at a lower appropriate rate, having regard to the overall tax liability of the Indian branch of the foreign bank. Upon the sharing of such a certificate with the borrower, it can withhold tax at the rate prescribed therein.
The act of withholding the tax is an obligation of the borrower, who is also required to issue a certificate evidencing this. The lender can take the credit of the tax withheld on interest to meet its tax liabilities in India as well as in the country of residence.
Interest paid on debt incurred to acquire equity or preference shares (held as capital asset and not as stock-in-trade) is not considered deductible for tax purposes.
Provisions dealing with thin capitalisation in respect of other interest payments are embodied in the Indian Income Tax Act 1961 (IT Act). These impose limitations on the deduction of excess interest (ie, any amount that exceeds 30% of the earnings before interest, taxes, depreciation and amortisation (EBITDA) of the Indian company or permanent establishment (PE)) incurred by way of interest or payments of a similar nature by an Indian company or a permanent establishment (PE) of a foreign company to its non-resident associated enterprise in respect of debt borrowed.
The thin-capitalisation rules are also applicable in instances of interest payments to third-party lenders who provide a loan on the basis of an associated enterprise, either providing an explicit or implicit guarantee to that third-party lender or depositing a corresponding amount with that lender.
Thin-capitalisation provisions are not applicable to Indian companies and PEs of the non-residents engaged in the banking or insurance business.
The above rules are applicable only where the interest or payments of a similar nature exceed INR10 million. The interest expense that is disallowed against income shall be allowed to be carried forward and allowed as a deduction against profits and gains of any business or profession carried out for up to eight assessment years, subject to the limits mentioned.
Other than in relation to the acquisition of a listed target (as discussed in 9.2 Listed Targets), there are no specific regulatory requirements to demonstrate certain funds.
Indian sellers may, in certain cases, expect bidders to demonstrate that they have binding commitments before selecting a winning bidder and executing definitive documentation.
Under the IBC, a resolution applicant (bidder for the company under a CIRP) is required to submit performance security after approval of its bid. The performance security will be forfeited if the resolution applicant fails to implement the resolution plan.
If an acquisition of a listed company triggers the requirement of making an open offer by the acquirer under the Takeover Regulations, the acquirer is required to fund an escrow account with the required funds in accordance with these regulations. The funds can be provided in the form of cash deposited in an escrow account, a bank guarantee issued in favour of the manager to the offer by any scheduled commercial bank or the deposit of frequently traded and freely transferable securities with an appropriate margin. Where the acquirer proposes to fund the escrow account by availing financing, the manager to the offer may need to be satisfied that the financing is available.
Disclosure of an Encumbrance on Listed Shares
Under the Takeover Regulations, shares taken by way of an encumbrance are treated as acquisitions and are required to be disclosed. Similarly, shares released from an encumbrance are treated as sale and are also required to be disclosed.
The Takeover Regulations have been amended and define “encumbrance” widely to include (i) any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly; (ii) pledge, lien, negative lien, non-disposal undertaking; or (iii) any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.
The SEBI, in its frequently asked questions on the Takeover Regulations, has clarified that any arrangement which risks the shares of the listed company being appropriated ought to be disclosed as being an encumbrance. Disclosure requirements apply to: (i) any acquisition of shares or voting rights in excess of 5% and thereafter any change in shares or voting rights so disclosed where that change is in excess of 2% when compared to the last disclosure; and (ii) any encumbrance created by the promoter on the shares of the listed entity.
Therefore, covenants or other conditions in the financing documents which have the effect of creating an encumbrance on the shares or voting rights of the listed company may require disclosures under the Takeover Regulations. Any such covenants may include any borrowing limits linked to the value of listed shares, a requirement to hold a specific number or value of the listed shares and a consent requirement for disposal of the listed shares.
Issuance of Listed NCDs
As a matter of recent practice, stock exchanges have sought audited financial statements for three years for any entity that proposes to issue NCDs which will be listed. This may impact deal structures which contemplate that a newly formed SPV will raise acquisition finance (specially where that SPV is an FOCC) by way of NCDs.
Despite having a vibrant mergers and acquisitions market, sophisticated acquisition finance structures are of relatively recent vintage in India. It is only in the last few years that the market has developed to encompass products which were otherwise commonplace in global markets.
The reasons for this can be primarily attributed to regulatory issues in the Indian market. These have made the traditional concept of a leveraged buyout much more difficult to implement in India than in other jurisdictions. While most of these regulatory restrictions continue to apply, the market has now evolved to embrace methods whereby acquisition finance is either structured in a manner that is compliant with local regulations, or is housed in a jurisdiction outside India while still enabling utilisation in India. Of late, private equity investors as well as strategic investors have recognised the need to structure their acquisitions in a manner that enables optimal returns, reduces default risk, and enables the utilisation of cashflows in the most efficient manner possible.
In this write-up, the authors have outlined some of the typical issues that confront transactions which involve acquisition finance, as well as the trends and developments that are seen in this space.
Historically, domestic acquisition finance has been primarily sourced from shadow banks or non-banking finance companies (NBFCs). This is because banks in India face considerable regulatory restrictions on lending for acquisition of shares. Further, the availability of equity or loan capital from the public markets in India is both time-consuming and expensive. Added to this is a relatively moribund debt market, which has made the raising of finance through bond issuances even more difficult. Since purely domestic private equity funds are both rare and small in size, their ability to assist with this has also been limited.
Foreign investors entering India also face challenges around structuring appropriate financing options. The traditional model of a leveraged buyout involved the raising of debt in the acquisition vehicle and the merger of the acquisition vehicle into the target, so as to enable the cash flows of the target to be used to pay off the debt. However, exchange control regulations in India restricted Indian companies with foreign investment from obtaining local loans to finance the acquisition of shares. These acquisitions had to be financed with equity from internal accruals or from offshore debt. The ability to raise offshore debt by Indian companies is also limited, since the routes that are commonly available, namely, the external commercial borrowings (ECB) route and the non-convertible debentures route, also had restrictions attached to them which rendered these options difficult to utilise. For example, the ECB route restricted the nature of the lender, the nature of the borrower, the use of the funds, the interest rate that could be charged, the minimum tenure of the loan, etc.
The issuance of non-convertible debentures to a non-resident subscriber also has the requirement that the subscriber should be a regulated and registered entity with authorities in India, as well as requirements for the listing of these debentures. More recently, requirements to increase the number of subscribers in any issue and reduce the concentration of any single investor in an issuance of debentures by a subscriber have also contributed to reducing the popularity of this method of financing.
The last few years have seen a number of products, structures and mechanisms that have been developed to assist in financing transactions in India. One of the primary drivers for this has been the increased popularity of buyout transactions in the private equity space. Global private equity funds now tend to focus on larger buyout transactions, in contrast to their earlier minority growth capital investments. The creation of a buyout market has increased both the requirement for healthy acquisition finance options, and at the same time has also increased the flexibility available to investors, enabling them to access options that might have been more challenging in other contexts. Alongside this, global strategic investors looking to acquire assets have also begun accessing options for financing from both global and local markets. As the size and value of transactions and assets in India grows, investors are increasingly considering the viability of various financing options.
The growth of the buyout market has given rise to the ability of the acquirer to control the cash flows of the target. A majority shareholder is able to direct the distribution of dividends or the utilisation of other cash resources available to the target in a manner that enables its ability to pay down debt. This provides comfort to both the borrower and the lender on the ability of the target to service the debt in accordance with its terms. Other mechanisms to enable or provide comfort on debt-servicing have also been introduced, include structuring the acquisition price by utilising deferred consideration, and even entering into supply contracts with the seller to guarantee the continued availability of cash flows to the target, thereby increasing its ability to service any acquisition finance debt.
Domestic financing options continue to be largely confined to non-banking finance companies, high net worth individuals and private equity funds. However, since the size and sophistication of these investors has increased, the possibility of obtaining large amounts of debt finance from non-banking finance companies, which are appropriately structured, including balloon payments, equity kickers, equity-linked interest rates, has enabled purchasers to utilise this source of financing in transactions.
One of the structures that may be considered to enable utilisation of domestic acquisition finance by a subsidiary of a foreign party is the acquisition of the undertaking of a business, rather than the acquisition of shares. As previously mentioned, companies with foreign investment are restricted from raising domestic acquisition finance by way of loans to acquire shares of other Indian companies. However, this restriction does not apply to the acquisition of assets or the acquisition of a business. As a result, it is not uncommon for companies with foreign investments to acquire the business undertaking through an asset purchase, rather than a share purchase, and to utilise acquisition finance for that purchase from local lenders. This structure, however, does have inherent limitations – for example, purchasing assets as opposed to shares could be tax-inefficient. It may also be more expensive, from a transaction-cost standpoint, since it may involve significantly higher amounts of stamp duty, as well as a longer timeframe, and other expenses in obtaining consents from contractual counterparties and lessors. Nonetheless, there are also certain inherent benefits in being able to cherry-pick assets and liabilities in an asset-purchase transaction that may make it more attractive than an equal share purchase.
While private equity has become a significant customer of acquisition finance, it is also one of the biggest sources of acquisition financing. Various equity and debt funds have entered India or have been formed in India, many of which view their ability to finance the acquisition of shares and assets by strategic investors or management teams as a healthy avenue for the deployment of capital. Again, the methods that are utilised to provide such financing vary. Given the nature of these vehicles, their willingness to provide more complex products has increased. In many instances, the debt provided is considered both high cost and high risk, and it is therefore critical for both parties to the transaction to assure themselves of the viability of the debt and its recovery. Options include the following.
The provision of debt by subscription to debentures
These instruments may provide for returns linked to the equity value of the target, the performance of the target, or even the exit valuation realised when the target is ultimately listed as otherwise sold. Many of these instruments provide for payment-in-kind (PIK) returns instead of more traditional cash payments of interest. Often, these instruments are fully secured, with charges over the shares of the target, assets of the target, and guarantees from the acquirer or its parent.
Participation in the equity of the acquisition vehicle
This enables the investor to participate as an equity partner along with the acquirer in the target. This is, in effect, a financial joint venture, where a strategic partner combines with a financial investor and enables the financial investor to rely on the technical expertise of the strategic partner while providing the capital itself.
The financing of management teams
The financing of management loans to enable their buy-out or buying of strategic assets has also become more popular. Examples abound of financial investors providing capital to management teams to enable them to form platforms and acquire assets with synergistic value and thereby gain economies of scale. There have been a number of these examples in the renewable energy space, the information technology services industry, and, more recently, the pharmaceutical sector. In many of these instances, the financial investor is in fact the largest equity-holder in the acquirer and management participation is structured in a manner that enables realisations of returns to the management linked to the performance in the venture.
Hybrid structures which combine the elements of debt and equity in such financing are gaining popularity. Investors consider these to be optimal in providing both reduction of risk by retaining the qualities of debt coupled with the benefits of an equity upside. Optionally convertible debentures, or debentures where interest rate is linked to the performance of the target, are popular in these structures.
The choice of the most appropriate route to utilise will depend on a number of factors, including tax implications, the availability of security, the extent of senior debt in the target, and the willingness of senior debt lenders to subordinate payouts themselves to enable the utilisation of cash flows to service the acquisition finance lenders. It should also be noted that the original lenders to the target are likely to be unwilling to cede any security to the providers of acquisition finance. As a result, the financiers are likely to be confined to security over the shares of the acquirer or the shares of the target, but often will not have any security over the assets of the target itself.
Distressed Assets Acquisition Financing
With the introduction of the Insolvency and Bankruptcy Code, 2016 in India, interest in the acquisition of distressed assets has increased considerably. Such financing comes with its own unique set of issues, often linked to the historical baggage attached to such assets. In order to provide comfort to a lender in such circumstances, it is crucial to ensure that the resolution plan for the asset concerned makes clear provision for the manner in which any new debt is to be secured and serviced, as well as providing clarity on any historical debt obligations of the target. Given that the insolvency process is primarily driven by the original lenders to the target, it is important to provide those lenders with suitable comfort as to the certainty and availability of financing, as well as the impact such financing will have on the target going forward, including its ability to continue to service any residual restructured debt that is owed to its original lenders.
Perhaps the most significant development of the last few years has been the exponential growth in offshore financing of Indian investments by foreign investors. The primary market for this has been buyout funds, which utilise this avenue to raise financing outside India and utilise these proceeds to invest into India alongside their equity investments. This loading of leverage enables them to reduce their cost of capital, since offshore debt financing and the interest rates thereon are relatively low, in comparison to the cost of equity capital as well as interest rates in India. On the negative side, the investments into India are structured as rupee acquisitions and hence the investor would face the risk of exchange rate variations.
Notwithstanding this risk (which is sometimes suitably hedged), a number of marquee buyout funds have found that the offshore acquisition finance market helps them to scale the returns considerably. This also enables them to bid more aggressively for assets in India, thereby giving them an advantage over a local acquirer whose only source of financing may be high-cost local debt. It should be noted that offshore financing of this nature has a number of issues which should be considered before a transaction is finalised.
Firstly, the security for such financing is typically confined to a pledge on the shares of the offshore acquiring entity. Obtaining security over the shares of the target, or the assets of the target, requires regulatory approvals from authorities in India, which are relatively difficult to obtain. As a result, in the case of a default, the financier can only access the shares of the acquirer entity, while the lenders to the target would usually have security over the assets of the target, and in some instances even the shares of the target. This can significantly hamper the ability of a lender to realise any value from the underlying security.
Secondly, as previously mentioned, the interest rate on the financing would be dollar-denominated, while the cash flows of the target are usually repealing.
Thirdly, the debt financing sits at the acquirer level and does not reach the targets directly. Therefore, the cash flows of the target are not directly available to service the debt. These cash flows are to be extracted in a suitable way from the target, in the most tax-efficient manner possible, and then utilised to service the debt. Given Indian restrictions on the extent of cash that can be utilised for dividends or buy-backs, coupled with the tax cost of such distributions, a significant amount of cost may be incurred in moving the cash flows from the target to the acquirer. Because of this, in part, offshore finance is often structured to enable the acquirer to utilise proceeds from an exit to service the bulk of the loan, in place of the periodic coupon.
Fourthly, the tax benefits of being able to set off interest payments against income at the level of the target may not be available, since the financing is not at the level of the target. This may also have an impact on the overall returns that can be generated from these structures. Nonetheless, the relatively easy availability of funds in the offshore markets at low interest rates has fuelled considerable popularity in this method of acquisition financing.
As the popularity and acceptance of acquisition finance grows in India, sellers have also become more circumspect about examining the certainty and availability of this finance while evaluating bids from buyers. For example, “certain funds' commitments”, “highly confident” letters, parent guarantees, equity-commitment letters, and similar mechanisms which could provide assurances to the seller as to the viability of a buyer are becoming a common part of market practice. Any bidding situation will include an evaluation of the method of financing as one of the criteria – taking into account the certainty of such financing, its timing implications, the implications that method of financing could have on the diligence process or on the extent of information or third-party consents that may be required.
The utilisation of third-party financing and the rights of the financier would also need to be considered by the partners of the acquirer, including in some instances any other shareholders of the target. The consequence of a default in servicing the financing, including the potential substitution of the acquirer by the financial year or its nominee, may also be a factor that a potential partner would consider; it is therefore important for an acquirer to demonstrate its ability to service the loan appropriately, or include suitable safeguards to provide comfort to its partners in this respect. Financial covenants imposed by lenders on the operations of the target may also impact its ability to undertake future expansion or growth or further acquisitions.
As previously mentioned, acquisition finance remains a relatively nascent field in India. However, global trends are likely to leapfrog many intervening steps to enter India. The development of the SPAC market globally is a trend that is likely to have a significant impact on the Indian merger and acquisition market. International buyers looking to acquire Indian assets are likely to examine special-purpose acquisition companies (SPACs) as a method to enable them to finance such acquisitions, while also providing liquidity and relative flexibility in operations.
As Indian companies continue to acquire global assets, the likelihood of their accessing both domestic and international acquisition financing for such acquisitions will also increase. While such acquisitions and where financing from international sources had become popular a few years ago, international acquisitions by Indian companies have been less common of late. Since many of these acquisitions did not realise their anticipated potential, they resulted in considerable stress on the acquirer as well as the target. As a result, any future acquisitions of this nature are likely to be more conservative in the extent to which they utilise international debt.
In the Indian market itself the focus is likely to stay on a combination of domestic and offshore financing, with more complex structures to ensure safeguards for lenders and financiers. Debt-financing documentation in India tends to be relatively lender-friendly, in comparison to international markets. However, as the size of the market increases and if liquidity continues to abound, sophisticated borrowers are likely to strengthen their negotiation position and Indian debt-financing documentation may begin to benchmark itself against international practices.