Contributed By Bharucha & Partners
This chapter addresses the trends in the Indian private equity sector in 2020. India is one of the largest private equity markets in the Asia-Pacific region with 2019 seeing the highest private equity and venture capital investments in the country in a decade.
In 2020, however, the COVID-19 pandemic and the resultant government-imposed nationwide lockdown have resulted in ongoing transactions being deferred and/or re-negotiated to reflect a change in valuations. Investors have shelved transactions on account of liquidity crunches and, in certain cases, re-directed their capital to revive and keep afloat, their existing portfolios. Ongoing transactions see investors focusing on the scope of material adverse change clauses and seeking stronger exit rights from the target.
Existing private equity investors have adopted a "wait and watch" approach as they gauge market recovery before exercising their exit rights. Nevertheless, certain sectors have continued to see market activity with investment gradually accelerating as the economy adapts to the new normal.
Bain & Co, in their "India Private Equity Report 2020" predict that the IT, ITES, digital entertainment (video streaming, gaming), fresh e-commerce, telemedicine, remote work and edu-tech sectors may see more funding in 2020. This is because COVID-19 pandemic has resulted in consumers relying more heavily on technology and technology-based services.
Edu-tech platforms have already seen investments in 2020 with BOND’s investment in BYJUs for an undisclosed amount and investments aggregating USD110 million by Facebook, General Atlantic, Sequoia and three other investors in Unacademy. Similarly, Reliance Jio (a telecom and data services company) has raised approximately USD2 trillion from multiple private equity investors such as Silver Lake and sovereign funds such as Abu Dhabi Investment Authority. Further, the Carlyle Group is investing USD235 million in Airtel’s wholly owned subsidiary, Nxtra Data.
Key Foreign Exchange Law Developments
In 2019, the Ministry of Finance, Government of India and the Reserve Bank of India (RBI), India’s central bank, notified the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 and Foreign Exchange Management (Debt Instruments) Regulations, 2019, replacing the erstwhile regime with an aim to simplify and bifurcate the regulation of debt and non-debt instruments and ease the approval process for transactions.
Foreign Portfolio Investment (FPI)
In September 2019, the Stock Exchange Board of India (SEBI), India’s securities market regulator, issued new guidelines recategorising foreign portfolio investors into two categories. Category-I consists of inter alia entities which are regulated (banks, insurance companies, investment managers, etc), pension funds and regulated funds from Financial Action Task Force compliant countries. Category-II entities are all foreign portfolio investors not classified as Category-I. In light of the COVID-19 pandemic, SEBI has eased the threshold for foreign portfolio investors registering as Category-I with the aim to boost portfolio investments. Category-I entities enjoy lower compliance requirements than Category-II entities.
Foreign Direct Investment (FDI) policy
Foreign investments in India are made either under the "automatic route" (ie, without regulatory approval) or under the "approval route" (ie, requiring specific consent from the relevant sectoral regulator). The Consolidated FDI Policy has been amended to liberalise foreign investments in sectors including contract manufacturing, single brand retail trading and digital media.
To curb opportunistic acquisition of Indian companies following the COVID-19 induced economic slowdown, as of April 2020, government approval is required for (direct and indirect) investment into India by persons resident in a country with whom India shares a land border (ie, China, Afghanistan, Bhutan, Myanmar, Nepal, Pakistan and Bangladesh). Previously, this restriction was applicable only in case of investments from Pakistan and Bangladesh. The operation of this amendment, however, has raised queries which remain unanswered, eg, the threshold for beneficial ownership which will trigger the requirement for government approval and the impact if any, on FPI and investment by venture capital funds. While stakeholders have sought clarifications in this respect, a response from the government is awaited.
Key Taxation-Related Developments
To attract investors, the government has abolished dividend distribution tax (where dividend was taxed in the hands of companies before being passed on to shareholders). The government also proposes to grant a ten-year tax holiday for companies which invest above USD500 million in inter alia medical devices, telecom, and electronics sectors.
Key developments by SEBI
In addition to the amendments to the FPI guidelines, SEBI has also eased certain acquisition related restrictions to allow aid by way of capital infusion in distressed companies hit by the COVID-19 pandemic. Further, SEBI has amended existing guidelines regarding infrastructure investment trusts (InvIT) and real estate investment trusts to increase investor participation in these sectors, including by introducing a new framework for privately placed unlisted InvITs.
In India, private equity investments are not per se regulated. However, certain private equity transactions may be subject to regulatory compliance or approvals depending on the nature of the target, the industry in which the target is engaged and/or the size of the target.
India-domiciled private equity investors invest through alternative investment funds which must be registered with the SEBI, while foreign investors may invest through any of the following routes:
There is no specific regulatory framework for acquisition of unlisted companies. Acquisitions of listed companies, however, must comply with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Regulations).
A transaction may require approval of the Competition Commission of India, India’s antitrust regulator, where the assets or turnover of the target, the investor (and, in some cases, the investor’s group) exceed specified thresholds.
Residents Outside India and Foreign Investors
The Indian Rupee is not freely convertible and transactions between Indian residents and persons resident outside India are regulated under Indian law. Foreign investment in certain sectors such as gambling and real estate is prohibited while foreign investment in certain other sectors is capped (eg, media) or permitted only with approval of the relevant sectoral regulator (eg, defence). Additionally, guidelines have been prescribed in relation to the price at which transfers between foreign investors and Indian residents can occur.
A private equity transaction is usually preceded by a detailed legal due diligence of the target, and its subsidiaries.
The diligence period generally covers the preceding three financial years and the key focus areas include review of the charter documents, existing shareholder arrangements for any restrictions on admitting new shareholders, material agreements and financing arrangements entered into by the target for any onerous obligations and, or, liabilities and consent requirements; compliance with foreign exchange laws, if applicable; and intellectual property rights and compliance with information technology laws. In India, many shareholders continue to hold physical share certificates, and ascertaining clear title of shares is important in case of a secondary market transaction. While due diligence is conducted primarily on the basis of the information and documentation provided by the target, it is common to also conduct public searches in respect of the corporate filings, intellectual property rights, litigation and materially adverse media reports.
Challenges, however, arise where the target is a public listed company. Under extant insider trading regulations, sharing of unpublished price sensitive information (UPSI) is prohibited. Whilst certain exceptions exist for the conduct of due diligence, UPSI shared during the course of due diligence usually needs to be made public prior to the transaction being completed. This requirement may disincentivise listed targets from sharing information during the diligence process.
Vendor due diligences are common in auction sales, though the private equity investor is often provided an opportunity to conduct a top-up diligence to verify the findings of the vendor diligence. Further, advisers usually do not provide reliance on the vendor diligence reports and, consequently, limited credence is provided to such reports.
Acquisitions of majority interest and asset purchases by private equity funds are uncommon in India. Private equity transactions are typically undertaken through private sale and purchase agreements for a minority stake. A transaction may, however, involve a court-approved scheme when it contemplates a pre-sale reorganisation of the target to streamline its businesses.
Private equity funds typically seek exclusivity with the target for an agreed period. Auction sales while not common in India, are held, in case of secondary market transactions for shares of companies listed on a stock exchange. In such cases, the scope for negotiation tends to be lower than in case of exclusively negotiated transactions.
Private equity funds typically set up special purpose vehicles to invest in targets. The fund’s representative will then be appointed to the board of the target. The fund is not, however, party to the acquisition or sale documentation and its direct involvement, if at all, is typically limited to the issue of a commitment letter providing a backstop on the indemnity obligations of the special purpose vehicle, which is a selling entity.
Private equity transactions are typically funded through the injection of equity by the private equity fund into the special purpose vehicle. However, funds do not generally provide equity commitment letters certifying certainty of funds for the transaction.
The RBI prohibits banks from granting loans for the purchase of shares. While non-banking finance companies may grant loans to private equity funds, this remains uncommon in India. The issuance of non-convertible debentures is less regulated than other modes of debt financing and, therefore, it is common for private equity investors to raise debt financing, where necessary through the issue of debentures.
While private equity funds typically acquired minority stakes in their targets, India has seen an increasing number of funds acquiring control in the concerned target. Specifically, in case of early stage companies, the majority shareholding is typically held by multiple private equity funds and not necessarily by the founders of the target.
Private equity transactions involving consortia of private equity sponsors are not common in India. However, India has seen a few deals involving consortia including the acquisition led by Brookfield Infrastructure Partners of the Jio tower assets of Reliance Industries for USD3.5 trillion in 2019.
Further, co-investments in the private equity context are also uncommon in India. Where there is co-investment, it is limited to the acquisition of passive stakes by limited partners alongside the fund, which is already an investor in the target.
In India, private equity funds typically invest with fixed price and, or, locked box consideration structures. The involvement of private equity funds as sellers or buyers does not affect the type of consideration mechanism used. Further, while earn-outs or deferred consideration are becoming a common feature of private equity transactions, per RBI guidelines, the deferred component cannot exceed 25% of the total consideration and must be paid within 18 months of execution of the transaction document.
Locked-box consideration structures are becoming more prevalent in the India private equity context. Where a locked-box mechanism is used, interest is charged on an agreed set of leakages including transaction costs, payment of dividend and bonuses to employees.
A dispute resolution clause specifically for the consideration structure is not common in India. However, the agreement customarily includes a generic, overarching dispute resolution clause for all disputes including those on consideration structure. In addition, referral to an expert or third party to break a deadlock on the consideration structures is also often included in the transaction documentation.
Private equity transactions in India are typically subject to regulatory, third party consents and other conditions, such as shareholder approval, lender consent, intimation to contracting parties and compliance with investor’s internal policies. Depending on the nature of the target, the investor, and the type of deal, the transaction may be subject to regulatory conditions as detailed in 3 Regulatory Framework.
Where the agreement between the target and the third party (such as a lender or commercial counterparty) requires consent for the transaction, such consent is included as a "condition precedent" to the transaction. The requirement for such consent is identified during the due diligence exercise conducted by the investor.
Separately, material adverse change provisions (usually with built-in cure periods) are customary in private equity transactions. Material adverse changes typically trigger termination of the agreement. The COVID-19 pandemic has brought greater focus on the definition of "material adverse change" and parties’ rights in respect thereof in the transaction documentation.
A "hell or high water" undertaking is common where the transaction is subject to regulatory conditions. In such cases, the transaction documents will include conditions requiring the buyer’s co-operation for obtaining such approvals.
Break fees are usually a matter of contractual agreement and are not common in the Indian private equity context. Indian law does not expressly regulate break fees or the terms or limits thereof. There are, however, several issues when it comes to payment of break fees. For instance, cross-border payments will require RBI approval, while break fees from listed companies may require SEBI approval.
Break fees, if paid, are restricted to reimbursement of actual expenses incurred by the receiving party in relation to the transaction.
Agreements for private equity investments may usually be terminated:
Private equity sellers usually assume very limited risk in relation to the target’s business, with warranties being restricted to the seller’s capacity and title to, and encumbrances over, the securities being sold. Liability in case of breach of the private equity seller’s warranties is also often limited by time and, or, quantum based on negotiations between the parties. While private equity buyers usually expect robust warranties in relation to the target’s business and operational matters, this is not usually the case where the seller is a private equity investor.
A private equity seller normally provides "fundamental" warranties regarding the title of the shares and the sellers’ ability to execute the transaction, to a buyer on exit. The target and its management separately provide commercial warranties regarding the target and its business.
The commercial warranties may be qualified with the knowledge of the target’s management and disclosures made by the target. In this respect, a full disclosure of the data room provided to the buyer or investor is not common and the target provides a separate letter with a limited set of disclosures against specific warranties. No such limitations and disclosures are typically accepted against the fundamental warranties.
The position does not differ when a buyer is a private equity fund. Typically, liability on loss for breach of warranties in case of commercial warranties (ie, other than fundamental warranties) is limited in time and quantum, for which the time period and amount, respectively, are heavily negotiated between parties.
Key protections for a private equity investor include:
Indemnities are usually provided for the various representations and warranties given by the private equity seller and management shareholders. However, as mentioned above, liability of a private equity seller is usually restricted to fundamental warranties. Although warranties and indemnity insurance are gaining popularity in India, it remains rare in the Indian context.
Further, an escrow or retention to back the obligations of the private equity seller is not common in India.
Private equity funds are slow to make claims against the target or its management and do not typically approach the courts in case of a dispute. To the extent that disputes do occur, these are usually in respect of the investor’s exit rights. Given the considerable backlog in Indian courts, arbitration is the preferred mode of dispute resolution.
Indian law does not contemplate outright public-to-private transactions. Under the Takeover Regulations, an acquirer must first acquire control of a listed company and thereafter commence the delisting process. However, delisting of listed companies is infrequent on account of regulatory issues arising out of the SEBI (Delisting of Equity Shares) Regulations, 2009 as well as the unfavourable pricing mechanism mandated therein.
Any person (including an acquirer) who, individually or together with persons acting in concert (PACs) with them, holds shares or voting rights aggregating to 5% or more in the target is required to disclose their holding in accordance with the Takeover Regulations. Thereafter, any change in shareholding of 2% or more is also required to be disclosed.
Additionally, any person, who alone or together with their PACs, holds shares or voting rights amount to 25% or more of a listed company is required to make annual disclosures of the aggregate shares or voting rights held by them.
Under the Takeover Regulations, a mandatory open offer is triggered:
Given the current financial crisis, until March 2021, promoters (ie, principal shareholders) may acquire up to 10% of the shares of a listed company in a financial year through a preferential issue without triggering a mandatory offer.
In addition to the above, a mandatory open offer is triggered where there is a direct or indirect acquisition of control of a listed company. The definition of "control" is inclusive and refers to control over management or policy decisions arising from shareholders’ agreements in the past, SEBI has tried to require that an open offer be made in the event of acquisition of negative control. This issue has yet to be resolved by SEBI and, or, the courts.
Although consideration other than cash (including through a share swap) is permitted in India, most private equity transactions in India have occurred for cash consideration only.
SEBI does not grant acquirers much flexibility and the only conditions that an acquirer may impose on an open offer are:
Financing arrangements need to be made prior to the open offer. Break fees may be negotiated between the parties. However, as discussed at Chapter 6.6 above, there may be regulatory hurdles at the time of payment.
At least 25% of the capital of a public listed company is required to be in the hands of the public. If, pursuant to an open offer, the public shareholding falls below 25%, unless the acquirer had announced an intention to delist at the time of making the open offer, the acquirer is required to dilute its shareholding to increase the public shareholding to 25%. Whilst a target may be delisted from the stock exchange, the promoters of the target cannot compel the public shareholders to surrender their shares.
Squeeze out of minority shareholders may be undertaken by unlisted targets (including those that have been delisted) in accordance with the Companies Act, 2013. Shareholders of a target holding 75% or more of the capital may squeeze out the minority shareholders through a scheme of arrangement sanctioned by the National Company Law Tribunal. Alternatively, a person who alone or together with his PACs holds 90% or more of the capital of a target may compel the minority shareholders to sell their shares to that person.
Except in the case of a hostile takeover, it is common for the promoters to make irrevocable commitments to tender their shares or vote. In such cases, negotiations between the private equity investor and the promoters would generally precede the open offer.
While hostile takeovers are not prohibited by Indian law, they are not often undertaken. Private equity buyers do not usually engage in hostile takeover offers.
Equity incentivisation of the management team within private equity transactions is not common in India. To the extent that such incentivisation is provided as part of the transaction, this is typically done through stock option plans where the option pool size is 5% to 10% of the share capital.
Indian law, however, prohibits the issue of such stock options to employees who are also promoters or part of the promoter group of a company. This prohibition extends to a director who holds more than 10% of equity in the company. Incentives, in such cases, are often structured as convertible instruments.
Management shareholders, where they participate in the transaction, typically subscribe to ordinary shares. Such participation does not extend to management personnel who are not shareholders. The company’s issue of stock options and sweat equity to incentivise such management personnel is independent of the transactions.
Stock options issued to management shareholders are typically granted over a four-year vesting period, with some options vesting each year.
Good and bad leaver clauses are generally the subject of negotiation especially in early stage companies where greater reliance is placed on the management of the company. Typically, for good leavers (ie, persons whose employment is terminated otherwise than for cause, death or disability), vesting of their options is accelerated. However, for bad leavers (ie, persons whose employment is terminated for cause), unvested options terminate and, in certain cases, the company has the right to buy-back vested shares.
Private equity investors typically require the re-execution of promoter and key employee employment agreements as a condition subsequent to their investments. These agreements usually contain non-compete and non-solicitation provisions which remain in force for one to two years following their termination.
Non-compete restrictions are enforceable while the employee is with the company. The likelihood of enforcing non-compete restrictions after the employee’s termination is low. Unlike other jurisdictions, India does not have a reasonability threshold to determine enforceability of non-compete restrictions post termination of employment as they are deemed as a restriction on trade except where the employee has sold their goodwill. Nevertheless, non-compete clauses usually include language clarifying that the employee agrees that the restrictions imposed are reasonable and necessary to protect the company’s business to deal with any evolution of the law which permits enforcement of such restrictions.
Minority protection for promoters is typically provided in the form of veto rights so long as the promoters hold a specific percentage of shares (usually 5% to 10%) in the company. A veto in this respect may exist for any change in control of and, or, key operational decisions in respect of the company’s business including termination of material agreements and making material financial commitments. Such rights, however, are not generally available in case of early stage companies or start-ups. Further, minority shareholders do not generally enjoy anti-dilution protection other than the option to subscribe to shares pro-rata to their shareholding in future funding rounds.
While veto rights allow the management shareholders some influence over any change in the company’s share capital, these rights do not apply to the private equity investor’s exit rights. Further, it is customary for the management shareholders to be obliged to facilitate the private equity investor’s exit.
Other minority protection rights like tag along rights and information rights will also extend to managing shareholders by virtue of their stake in the company.
Private equity investors nominate directors and/or observers to the board of directors of the target while the promoters manage the day-to-day affairs of the target. The role of the nominee director(s) is to ensure rights of the private equity investor are protected primarily through the exercise of affirmative voting rights over matters material to the private equity investor. These rights inter alia include changes in capital structure, nature of business, transactions above a certain threshold. The private equity investor also typically has rights relating to information and inspection, audit control and appointment of senior management persons.
Generally, shareholders of a company are not responsible for the actions of the company. Shareholders may only be held liable where the corporate veil is pierced by the courts. Piercing the corporate veil occurs only in exceptional cases. In the past, the corporate veil has been lifted:
Upon lifting the corporate veil, courts are likely to impose liability on those shareholders whose knowledge, consent or connivance has been established.
It is common for private equity investors to require targets to adopt the investors’ internal policies and compliance protocols. The nature of the policies and protocols so adopted varies depending on the investor, the size of the investment, the business in which the target is engaged, etc.
A private equity investor usually holds its investments for an average period of four to seven years depending upon the sector of investment and deal size. Usually, the preferred exit routes for private equity investors are initial public offerings (IPO) and/or secondary sales to another institutional investor. Dual-track processes are also common. In 2020, there has been a slowdown in both private equity transactions and private equity exits on account of the economic impact of COVID-19.
It is not common for private equity investors to reinvest upon exit.
While transaction documentation typically includes a drag right for the private equity investor, this right is rarely exercised. Where there are multiple investors, the drag right lies either with the single largest institutional investor or a group of investors who have the power to collectively exercise the drag right. The drag right ceases to exist upon the investor’s shareholding falling below a certain negotiated percentage (usually 10%). A drag right is usually available against all shareholders (including other institutional investors).
Tag rights in favour of management shareholders are uncommon as such rights could have an adverse impact on the ability of the private equity investor to exit. Tag rights, where granted, are usually triggered if a controlling stake is being sold.
Following an IPO, the shares held by non-promoter shareholders prior to the issue are subject to a lock-in period of one year from the IPO’s date of allotment while pre-issue shares of the promoters are subject to a three-year lock-in. There are specific exemptions to select categories of investors. It is uncommon for a private equity investor to have special rights following an IPO, since the same is not viewed favourably by SEBI. Where such rights are granted, they would usually be enshrined in the constitutional documents of the target.