Recent Trends in PE and M&A Activities
In early 2022, India witnessed robust M&A activity driven by stable financial performance of domestic companies, as well as such companies’ requirement to expand operations. However, in 2023, M&A deal flow experienced a decline, mirroring trends seen in other sectors.
Furthermore, the private equity sector also reflected global trends, resulting in lower investment activities in 2022 as compared to 2021. As per publicly available reports, the value of private equity transactions dropped by over 40% in 2022, reaching approximately USD62 billion, down from nearly USD70 billion in 2021. This decline, as per reports, continued in the first quarter of 2023, with a 66% reduction in investment value as compared to the first quarter of 2022. Nonetheless, it is anticipated that private equity deal volume will stabilise in 2023, with the potential for more favourable valuations as well as general improvement in market sentiment.
Having said this, India witnessed a marginal increase in deal volume for impact investing in 2022. As per reports, it is estimated that the first quarter of 2023 saw impact investments of approximately USD1 billion.
Sectors Dominating the PE and M&A Landscape
The technology sector emerged as a prominent player in private equity and M&A deals in India, driven by the increasing demand for tech-enabled solutions. In 2022, the technology sector attracted investments of close to USD20.5 billion, with notable deals involving companies like DailyHunt and Swiggy. The first quarter of 2023 continued the trend, with technology sector deals such as the USD500 million investment in Lenskart and USD450 million investment in PhonePe.
Additionally, the BFSI (banking, financial services, and insurance) sector accounted for significant investments, with reported deals worth USD5.3 billion in 2022. This was led by investments in YES Bank by Advent International and Carlyle, and buyout of IDFC Asset Management Company by GIC, ChrysCapital and others.
Furthermore, the energy sector also saw substantial investment in 2022, primarily focused on renewable energy companies, which was led by investment in renewable energy company, ReNew Surya Roshni by Mitsui PE and others. The first quarter of 2023 recorded the mega funding of USD700 million in the Genko Group.
Another prominent sector was healthcare, which witnessed steady growth in investments, led by deals such as acquisition of significant stake worth USD762 million in Suven Pharmaceuticals by Advent International in 2022. During the first quarter of 2023, as per publicly available information, companies in healthcare and life sciences space garnered investments close to USD800 million, contributing towards almost 20% of the deal volume in India. The first quarter of 2023 also witnessed a buyout worth USD300 million of the beauty and wellness company, VLCC Wellness. by global private equity investor, Carlyle. This trend has continued in the second quarter of 2023, which further recorded deals such as Temasek’s acquisition of an additional 41% stake in the Manipal Hospitals for USD2 billion, marking one of the largest deals in the Indian healthcare space. Healthcare has also witnessed successful exits such as the exit of KKR from Max Healthcare, coupled with IPOs of hospital chains such as Medanta and Rainbow.
Investments in infrastructure companies has shown sustained growth with investments in companies like Welspun Enterprises and Eastern Peripheral Expressway, which are among the top ten private equity investments for the year 2022.
ESG in PE
Environmental, social and governance (ESG) conscious investing continues to be an emerging space as private equity funds showed a strong inclination towards companies with concrete ESG practices.
The key developments which have brought changes to the regulatory landscape and influenced investment decisions are set out below.
Indian Companies Act, 2013
In 2022, the Ministry of Corporate Affairs (MCA) introduced amendments to restrict the entry of citizens and entities domiciled in India's land bordering countries into Indian companies. This move was in line with the Press Note No. 3 (2020 Series) issued by the Reserve Bank of India in 2020 to regulate acquisitions by neighbouring nationals/citizens over Indian companies. The amendments require submissions of documentary evidence of compliance with the aforementioned conditions to the relevant authorities.
Additionally, the MCA introduced a mandatory security clearance for persons from India's land bordering countries appointed as directors on the boards of companies. Although this amendment applies to prospective appointments, it underscores the need for security clearance from the Ministry of Home Affairs for such directors.
Foreign Direct Investment (FDI)
Over the past three years, the Ministry of Commerce and Industry has made several amendments to the consolidated FDI policy. These changes relaxed thresholds in various sectors, such as insurance, telecom, defence, and oil and gas. Notably, FDI limits in the insurance sector were raised to 74% under the automatic route in 2021, and the telecom sector saw an increase in the FDI limit to 100% under the automatic route in the same year. Such amendments have encouraged foreign investment inflow into these sectors and contributed to the growth of the Indian economy.
Overseas Direct Investment
On 22 August 2022, the Reserve Bank of India (RBI) released FEMA (Overseas Investment) Regulations, 2022 (OI Regulations) to nationalise the regulatory framework relating to overseas investments by people who reside in India. Some of the key amendments are as follows:
Financial Sector Regulations
On 20 September 2022, the RBI issued guidelines on digital lending, which have significant implications for various banking and non-banking financial companies.
Key clauses of this amendment include:
In addition, on 8 June 2023, the RBI introduced default loss guarantee guidelines that outline key compliances for first loss default guarantees in digital lending, applicable to various banking and non-banking financial companies.
While these amendments have necessitated re-evaluation of fintech business models, private equity firms remain keen on investing in the technology-driven financial service model. The evolving market dynamics show that private equity firms are embracing the fintech companies despite regulatory constraints.
SEBI Listing Regulations
Through various consultation papers issued over the last year, SEBI has introduced material amendments to the governance framework for listed companies – ie, the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the "Listing Regulations").
The amendments to the Listing Regulations include modifications, which are:
Amendment to AIF Regulations
SEBI amended SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) by:
Development in Gaming Sector Laws
On 10 April 2023, the Ministry of Electronics and Information Technology introduced new regulations called ‘The Online Gaming Intermediaries Regulations, 2023’ primarily for online real money games where the user makes a deposit in cash or kind with the expectation of earning winnings on that deposit. Such online real money games need to be registered with a self-regulatory gaming body. The regulations apply to intermediaries who enable the users to access online games.
Furthermore, from a tax perspective, the government has indicated that it will be imposing a 28% tax on funds that online gaming companies collect from their customers. This is a material setback for companies in this sector and will be an important consideration for private equity investment in this sector as the same will impact the existing valuation as well as future cash flows.
Development in Tax Laws – Angel Tax
On 24 May 2023, the Ministry of Finance amended the provisions relates to angel tax under the Income Tax Act, 1961, which is applicable to companies on the receipt of consideration for the issuance of shares in excess of the fair market value of the shares of such company. The relaxations in the applicability of angel tax has now been expanded to cover foreign investments from certain jurisdictions effective from 1 April 2023. However, investments made inter alia by venture capital undertakings, category I or category II alternative investment funds, category I foreign portfolio investments, endowment funds, and pension funds of 21 notified jurisdictions are exempted. This angel tax could have implications for offshore funds in popular jurisdictions such as Mauritius or Singapore, which are currently not a part of the ‘exempted list’ of countries.
The regulatory environment for private equity funds and transactions in India is overseen by various key regulators, each playing a crucial role in ensuring compliance and investor protection. In recent times, there have been notable developments in merger and acquisition regulations, foreign direct investment norms, and a growing emphasis on environmental, social, and governance (ESG) compliance.
Primary Regulators for Private Equity Funds
The Reserve Bank of India (RBI) is the key regulatory authority for foreign direct investment (FDI) in India. The Foreign Exchange Management Act, 1999 (FEMA), consolidated FDI Policy Circular of 2020, and FEMA (Non-Debt Instruments) Rules, 2019, govern foreign investment transactions. The foreign exchange regulations also distinguish FDI investments from foreign portfolio investments (FPI). FPI investors are from offshore entities, hold an FPI registration, and invest in India through equity instruments where such investment is less than 10% of a listed Indian company.
SEBI is the primary regulatory body governing private equity funds in India. SEBI's oversight extends to venture capital, private equity funds, and pooling vehicles operating as Alternative Investment Funds (AIFs). The SEBI (Alternative Investment Funds) Regulations, 2012, as amended, lay down the regulatory framework for AIFs, prescribing investment restrictions and conditions for different categories of funds to safeguard investors and manage risks. Some of the relevant provisions for foreign direct investment include:
Obtaining regulatory approvals and navigating lengthy disclosure requirements may present challenges.
Regulatory Issues in Merger and Acquisition Laws
Mergers and acquisitions in India are governed by a framework that includes the Companies Act, 2013, Competition Act, 2002, FEMA laws, and SEBI Act, 1992, along with rules and regulations.
Key regulators for a merger differ based on the type of company involved. For private and unlisted public companies, the National Company Law Tribunal (NCLT) serves as the primary regulator. For public listed companies, in addition to the NCLT, SEBI acts as a regulatory authority.
Noteworthy provisions in merger control include:
The Competition Commission of India (CCI) is a key regulator for combinations involving mergers, acquisitions, or amalgamations that surpass specified deal value thresholds. An important amendment allows transactions falling under the Green Channel route to be deemed approved by the CCI, streamlining the process. Furthermore, the Competition Amendment Act, 2023, introduced a provision of “deal value threshold” which states that any deal that has a value of more than INR2000 crores and where the target has “substantial business operations in India” is required to get an approval from the CCI before heading towards the combination. The date of enforcement of deal value threshold provision is yet to be notified by Government.
Recent Changes in ESG Compliance
In recent years, ESG considerations have gained prominence in private equity investors' value creation and exit plans. India does not have a specific regulatory framework for ESG; instead, various laws address ESG-related aspects, including environment protection, corporate governance, and mandatory corporate social responsibility.
Recent developments include:
Much like its global counterparts, due diligence is a vital step in private equity as well as merger and acquisition transactions in India. A well-structured due diligence process is an initial step of any investment decision.
The diligence exercise plays a crucial role in private equity transactions by providing a comprehensive assessment of a company's legal standing, identifying potential risks, liabilities, and other pertinent issues that may impact the deal. Typically, a detailed legal due diligence questionnaire is prepared to ensure a meticulous investigation of the target company.
Key Areas of Focus for a Legal Due Diligence in Private Equity Transactions
The legal due diligence process in private equity transactions centres on reviewing the following key aspects:
Generally, the following issues, if they arise, are material for a private equity investor to focus on:
Recent Trends and Lessons From Start-Ups
Recent years have witnessed various start-ups, making headlines due to corporate misgovernance and financial discrepancies. These instances have raised questions on the adequacy of information or scrutiny for such governance issues.
In order to address such pitfalls, founders and investors have placed increased emphasis on corporate governance in their due diligence process. Furthermore, robust internal controls, transparent financial reporting, and adherence to regulatory guidelines are being adopted, thereby ensuring a more secure investment landscape for private equity transactions.
The use of a vendor due diligence (VDD) is a significant feature in certain company-driven or competitive deals. VDD involves the target company providing essential information to potential buyers, including details about its business, financial condition and legal standing. This information is analysed by prospective buyers to assess the associated risks of the acquisition and safeguard their interests post-closing.
Scope and Documents in Vendor Due Diligence
In VDD, the target company's representatives are required to prepare a comprehensive VDD report, which serves as the primary source of information for potential buyers. The report highlights key aspects of the target company, enabling buyers to make informed decisions regarding the transaction. Alongside the VDD report, buyers are also provided with key documents to supplement the findings stated therein. The scope of these documents is typically limited to additional information requested by buyers to gain clarity on the issues highlighted in the VDD report.
Reliance on Vendor Due Diligence Reports
Unlike some other jurisdictions, in India, sell-side advisers or target companies do not typically provide reliance on the vendor due diligence reports. While the VDD report can serve as a helpful resource for buyers, it is essential for investors to independently request for material diligence documents and have discussions with the target company to address any key issues referenced in the VDD report.
Access to UPSI vis-à-vis VDD
In the case of listed entities, disclosure of unpublished price sensitive information is restricted unless:
Private equity investments as well as acquisitions are predominantly structured through the primary or the secondary route, or a combination of both. Private equity funds typically enter into share subscription or share purchase agreements for subscribing into new shares or purchasing the existing shares of the target company, in the form of equity or preferred stocks or a mix of equity and preferred capital, for cash or non-cash considerations paid in immediate or deferred basis. With respect to foreign private equity funds, hybrid instruments are not customarily contemplated as foreign direct investment in India and are permissible through equity shares, compulsorily convertible shares and compulsorily convertible debentures, as opposed to instruments which are optionally convertible or are non-convertible, which are considered as external commercial borrowings and are governed by separate regulations.
A court-approved scheme is preferred in scenarios for a merger of companies or where a company opts for reconstruction of its capital and its assets with the approval of the court and its shareholders prior to the sale/acquisition.
In India, private equity backed buyers conventionally acquire the target directly rather than establishing a separate SPV for pooling of funds. Having said this, it would be more customary for offshore acquisitions by Indian companies to establish an offshore SPV to pool fund or raise debt.
Generally, the acquirer directly leads the documentation and negotiation process. However, the specific level of involvement of the private equity fund in the documentation process may vary depending on specifics of the acquisition/sale (for example, if the acquirer is controlled by the private equity investor).
Financing of PE Acquisitions
Private equity transactions are traditionally financed through a combination of debt and equity. The details of such a fusion of equity and debt depends on a number of factors such as the size of the deal, stage of the target company and risk profile of the investment. The equity component is infused by institutional investors and a pool of private capital deposited in the private equity fund, which is used to pay for the equity investment. There is also an increasing tendency towards infusion of capital by high-net-worth individuals in acquisition transactions involving private equity funds in India, where HNIs invest directly in the target companies or invest through private equity funds.
The debt component is conventionally provided by financial institutions or private debt funds. However, acquisition financing is generally not permitted by Indian banks, except in certain limited circumstances. However, non-banking finance companies (NBFC), alternate investment funds and mutual funds may provide financing for acquisition of shares in India, provided they meet prudential and concentration norms. Non-convertible debentures (NCDs) are another method of debt financing, however, the extent of regulation of NCDs depend on it being listed, unlisted, publicly or privately placed. Privately placed unlisted NCDs are a popular form of debt financing for foreign private equity investors. NCDs are offered and sold directly to a select group of investors and have a pre-determined short-term tenure. Furthermore, in case of an investment by a foreign owned and controlled company, the Indian entity is not permitted to use borrowed funds for the purpose of making downstream investment.
There is an emerging trend within private equity consortium culture that India has witnessed in the recent years. Private equity funds most typically collaborate with other private equity funds or corporates to invest in target companies as a consortium. Co-investments involving the acquisition of passive stakes by limited partners along with the private equity funds that are already investors in the target companies are also significantly evidenced in the private equity landscape. The consortium brings to the table the complementary skills, expertise, resources and networks of different private equity funds and investors, which in turn are instrumental to supporting upcoming business and help to yield maximal profits on their investment.
Private equity transactions employ various consideration mechanisms, each tailored to meet the specific needs of the parties involved. These mechanisms include fixed price with or without locked-box, completion accounts, and share swaps. Additionally, while deferred consideration structures feature in private equity deals, transactions involving non-resident or foreign parties must comply with foreign exchange regulations when incorporating deferred consideration.
Consideration Mechanisms in Private Equity Transactions
Deferred Consideration in Private Equity Transactions
If non-resident or foreign parties are involved, these transactions must adhere to specific foreign exchange regulations.
In addition, the parties involved in private equity transactions take various protective measures to safeguard their interests. These protections may include indemnity holdbacks and escrow arrangements. The impact of private equity fund involvement on these protections may differ compared to a corporate seller or buyer.
Under certain cases, reverse charge interest may be charged on any leakage that may occur during the locked-box period. Typically, leakages can be in the form of transfer/disposal of assets, write off of any receivables, dividends. Having said this, there are certain leakages which are permitted, such as remuneration to the employees in the ordinary course of business and general administrative and management costs.
The majority of private equity transactions have institutional form of arbitration as the preferred mode of dispute resolution. The choice of dispute resolution does not really vary based on the consideration structure used under the transaction. However, the computation of the consideration amount which is in dispute among the parties is typically ascertained by an expert customarily from amongst the Big Four accounting firms.
Furthermore, we have seen a general tread of parties adopting arbitration administered by the Singapore International Arbitration Centre with the seat of law being in India or Singapore (which is a negotiated point based on each party’s preference).
Private equity transactions are typically subject to:
Furthermore, the concept of ‘material adverse change’ (MAC) is quite common under private equity transactions in India. MAC accords the contractual protection to the acquirer to terminate the agreement or not proceed towards funding for events which effect the validity of the transaction documents or which have an adverse impact on the financials or business of the company. The concept as well as the definition is similar to that as adopted in UK or Singapore.
Hell or high water conditions typically depend on a case-by-case basis in private equity transactions in India. There are certain sectors under foreign investment conditions wherein foreign investment above a certain threshold requires regulatory approvals and certain conditions to be followed. Similarly, there are certain monetary thresholds prescribed under the merger control regime in India for which parties are required to take regulatory approvals.
Therefore, depending upon the sectors under foreign investment and the monetary thresholds under the merger control, hell or high water undertaking is negotiated under a transaction. However, as a general rule, depending upon the applicable rules and regulations, the hell or high water conditions are commonly undertaken on a ‘reasonable’ or ‘best efforts’ basis by the parties involved.
In India, break fees as well as reverse break fees are not common and typically depend contractually on a deal-to-deal basis. Having said this, given a few high profile acquisitions which have not been completed or failed in the last twelve months, a larger push has been made by target companies to include this concept in the documents.
From a legal perspective, there are no specific laws which govern the trigger and volume of such break fees and it contractually depends upon the parties involved. However, an overarching principle is that such break fees should not be punitive in nature and are captured as ‘liquidated damages’. Having said this, remittance of break fees from an Indian counterparty to an offshore party may require regulatory approvals.
Under an acquisition agreement, both the buyer as well as the seller are provided with the right to ‘mutually’ terminate the agreement, if so decided and agreed and in case the transaction is not consummated and closed within the long stop date.
However, there are certain additional protections accorded to the buyer wherein buyer can unilaterally terminate the agreement in case of:
Typically, a long stop date is negotiated between the parties depending upon the time required for the completion of pre-funding obligations by both the parties. However, subject to the nature of conditions precedent, a period of 45-60 days from the signing of the documents can be considered a reasonable timeline for the same. If any specific governmental or anti-trust approvals are required, then this time period will need to be adjusted.
The overall allocation of risk differs in a deal where the seller or buyer is a corporate or an institutional fund. In instances where institutional funds are sellers, the representations and warranties provided to the counter party are limited and primarily restricted to authority, title, tax and capacity. Furthermore, the indemnity obligation is also limited (capped in amount and time) as opposed to an open-end liability in case of promoters or founders.
Private equity sellers customarily provide only fundamental warranties limited to title to shares, tax, authority and capacity. Furthermore, depending upon the fund life and the nature of the transaction:
Furthermore, under an exit, management as well as the company provide additional business warranties to the buyer and the corresponding indemnity. Customarily, monetary limitation on such warranties can vary from 100% of the consideration to uncapped in relation to breach of fundamental warranties and occurrence of fraud.
In addition, while a generic disclosure against the data room is not accepted against the warranties, the seller can have a disclosure against the specific warranties. Having said this, disclosure against fundamental warranties are not usually accepted by the buyer.
Apart from the protections as mentioned in 6.9 Warranty and Indemnity Protection, the warranty and indemnity insurance may also be explored by the buyer or the seller. Warranty and indemnity insurance is, typically, prevalent in cases where there is an indemnity time limitation on the seller on account of its fund life or if the management of the seller is not founder driven. Having said this, the cost for business warranties are typically covered by the target company or split pro-rata among the selling shareholders, and tax insurance is obtained independently by the offshore sellers participating in the sale of securities.
In addition, parties also consider an escrow or retention mechanism wherein a certain percentage of the consideration, to be paid to the seller, is held in escrow to back the indemnity obligations towards the buyer for the breach of the warranties. If the transaction involves a non-resident, then the escrow mechanism is to be in compliance with foreign exchange regulations.
In terms of recent commonly litigated provisions, allegations of fraud, siphoning of company’s funds by the founders/promoters, non-arm’s length related party transactions, breach of business related representations or misstatement in the accounts of the company have been a feature. Another key aspect or area of contention are breaches of exit related clauses by the company or founders.
Customarily, the shareholders’ agreement will address the manner for assessment as well as the consequences of these breaches. The consequences for founder breaches will also include a termination of the employment on the account of the fraud as well as a clawback of securities and resignation from all positions in the company. However, we have seen that such actions initiated are challenged by the founders/promoters and are subject to protracted negotiations or an arbitration process.
There are instances of public to private transactions, however, they are not as prevalent as transactions involving private companies going public by way of listing.
Public to private transactions in India are regulated by SEBI (Delisting of Equity Shares), Regulations, 2021. There have been relatively few public to private transactions on account of the limited effectiveness of purchasing the residual shareholders and the reverse book built price mechanism as provided under the aforementioned regulation.
Furthermore, relationship agreements are entered between the bidder and the target company on a case-by-case basis and such agreements typically includes provisions regarding terms of sale of payment terms, mechanism for regulatory approvals and confidentiality.
Under the terms of SEBI (Substantial Acquisition of Shares & Takeovers) Regulations, 2011:
Furthermore, an acquirer, together with PAC, holding shares or voting rights equivalent to or more than 25% of such listed company shareholding is required to make annual disclosures under the Takeover Regulations.
In addition to this, SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, mandates a quarterly shareholding pattern disclosed by listed entities in India. The shareholding pattern is required to be disclosed across three broad categories:
Furthermore, pursuant to the amendment in 2022 under the Listing and Disclosure Regulations, listed companies are now required to provide shareholding details on more categories of shareholders (eg, sovereign wealth funds, foreign portfolio investors, foreign direct investment, foreign companies, foreign nationals and non-resident Indians) which are now required to be separately disclosed categories.
The takeover regulations require a mandatory open offer under the following circumstances:
In addition to this, if the acquirer already holds a stake that is 25% or more but less than 75% of the target company and in case it acquires 5% or more of the shares/voting rights in the target company within a financial year then, under such a circumstance, the acquirer is required to make an open offer. Having said this, this obligation is subject to the exemptions provided under the Takeover Regulations such as acquisition pursuant to a scheme of arrangement approved by the National Company Law Tribunal (NCLT) or any insolvency resolution proceedings.
For investment transactions, cash is the most common form of consideration. However, M&A transactions have a combination of shares as well as cash.
Furthermore, all non-resident persons are required to comply with the RBI pricing guidelines on ‘fair market value’ such that no share is sold or transferred to any non-resident party below the ‘fair market value’ of such shares.
In addition to the mandatory open offer requirements as set out in 7.3 Mandatory Offer Thresholds, the takeover regulations also prescribe conditions for an acquirer for voluntary open offer, offer size, mode of payment under the offer and withdrawal of offer.
The financing documents by and between the acquirer and the target are entered and executed prior to the open of the tender offer so that, in addition to the regulatory requirements under the securities law, the rights and obligations of the acquirer as well as the target are documented contractually.
The takeover regulations require that at least 25% of the share capital of a public listed company should be held by the public at all points in time.
In the event that the public shareholding falls below 25% during an open offer then the acquirer is required to dilute its shareholding to an extent such that the public’s shareholding in the listed entity is at least 25%. Alternatively, the acquirer can delist as well at the time of making open offer in such a situation.
Subject to the above, the Indian Companies Act, 2013 also includes provisions for ‘squeeze outs’. However, minority shareholders can object to such squeeze out mechanisms on the grounds that it is not is fair and reasonable to the minority shareholders and can block expeditious methods of minority buy out.
Typically, negotiations usually precede the trigger of open offer by the acquirer to buy the shares in the listed company. The acquirer as well as the promoters and management negotiate the transaction and enter into definitive documents to crystalise the rights and obligations which would flow upon the trigger of the open offer.
Equity incentivisation of the management-level personnel is a common feature in private equity transactions in India, wherein the companies offer certain incentives (such as employee stock options (including phantom stock options), incentive-linked payments and bonuses, and stock appreciation) to ensure that the private equity investments meet the milestones as agreed with the investor(s). In addition, the management team may be issued shares for consideration (other than cash) as an incentive for achieving the performance parameters or facilitating an exit to the institutional investors or listing of the securities.
The companies typically allocate an option pool which varies from 7-10% of the share capital of the company. The ESOP pool and structure is dependent on the type of company and the industry in which it operates and any commercial policies that the companies and its investors may implement to incentivise the employees. Furthermore, recent trends show that these incentive equity grants are subject to vesting and performance thresholds, in addition to repurchase rights on termination of the employment.
Having said this, an ESOP pool created under or pursuant to the Companies Act excludes an employee who is a founder or a director (who either by himself or through a relative, body corporate holds more than 10% of the outstanding equity shares of the company) for such issuance. This rule is not applicable to a start-up company for a period of five years from the date of its incorporation or registration.
The term ‘sweat equity shares’ is defined in Section 2(88) of the (Indian) Companies Act, 2013, and is subject to certain restrictions such as:
Therefore, in private equity transactions, the management shareholders’ participation is typically conducted through:
These options provide the investor as well as the management team with more flexibility to structure the transaction.
In early-stage companies, the shares held by the founders are subject to a vesting period of four years (whereby the shares shall vest equally on a monthly or quarterly basis over such a period) with a one year cliff period.
In the event a founder’s employment with the company is terminated or upon their resignation on or before the vesting of all shares, then the unvested shares are typically repurchased by the company (or its nominee) or transferred to the ESOP pool/trust of the company at face value. However, there are certain exceptions built in for ‘good leaver’ scenarios.
In case of termination on account of ‘Cause’, the vested shares are also bought out or transferred at a discounted value.
Private equity investors seek the investee company to impose certain restrictive covenants on the founders or key employees, such as limited ability to transfer their shares or invest in other companies, exclusivity, non-compete, non-solicitation and confidentiality. The investors may also seek to amend the terms of the employment agreement of such founders/key employees to ensure that any such employee or founder exiting the company will not be eligible to work with or set up a competing business and/or solicit employees; and confidential information of the company is not disclosed to any third party not intended to have access to such information.
Non-compete obligations which are linked to the shareholding of a founder and are related to the transfer or protection of ‘goodwill’ would be enforceable under Indian law. Other types of non-compete obligations which extend beyond the term of a contract are ordinarily held to be invalid.
Non-solicit covenants are generally enforceable under Indian law.
The management shareholders are generally provided governance rights (which include a seat on the board of directors of the company) in addition to the equity ownership in the company. Based on their shareholding percentage in the company as well as the structure of the board, the management/founders may also be provided limited veto rights on key operational or strategic matters relating to the company. However, management shareholders are typically not entitled to anti-dilution protection.
Investors negotiate for a range of control mechanisms over their portfolio companies to actively participate in decision-making and monitor financial performance. These mechanisms, including board appointment rights, observer seats, affirmative voting rights, information/inspection rights, and involvement in key managerial personnel appointments, empower private equity fund shareholders to safeguard their investments and contribute to the long-term success of the portfolio companies.
The affirmative rights include matters such as related party transactions, change in business, alteration of charter documents, corporate restructuring, appointment and removal of key managerial personnel, liquidation, or dissolution of company, exit related provisions, litigations, annual budgets and business plans and strategic initiatives.
In India, the corporate shareholders are typically not liable for the debts or obligations of the company, including legal liability for torts or contractual actions. However, a court may disregard the corporate protection granted to such shareholders and hold them personally liable in certain exceptional situations wherein piercing of corporate veil establishes the knowledge or intention of such shareholder in the alleged wrongdoing, fraud, money laundering or tax evasion.
The exit strategies typically negotiated by private equity firms include private sales to other private investors or corporations and initial public offerings (IPOs), however, other forms of exit include:
A dual-track process provides an opportunity for private equity investors to explore the public market while seeking a strategic purchaser or another financial investor. However, it is an expensive procedure for the company and it is difficult for the management to allocate recourses to fully commit to evaluating both options in parallel.
Drag as well as tag-rights are a common feature in equity transactions.
Typically, a drag is initiated post the exit period or in an event of default. This right is triggered by major financial investors aggregating to at least 51-67% (as applicable) of their inter-se shareholding. Furthermore, the participation of the founders in such a drag sale can be made necessary, including providing customary representations, warranties and indemnities as required by the third-party buyer. Lastly, if the drag sale does is not comprised of shares held by investors (other than the dragging investors), then the minority investors negotiate a tag-along right to enable them to participate in such transaction.
With regard to the tag transactions, the same is linked to a sale of securities of the founder. The tag-along is customarily on a pro rata basis with the founder(s). However, a full tag is provided to the investors if such a transfer results in a change in control or the founder’s shareholding falling below a negotiated threshold.
Lastly, the parties may also negotiate to include the concept of a housekeeping tag, whereby transfer of shares by one or more shareholders to the third-party buyer results in a change of control scenario. In such a scenario, each shareholder (other than the selling shareholders) shall have the right to require such a third-party buyer to purchase up to all their shares held in the company on the same terms and price offered to the selling shareholders as part of such sale.
Lock-in restrictions are governed by the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. As per these regulations, subject to certain exceptions and categories of investors, the entire pre-issue capital held by persons other than the promoters is locked-in for six months from the date of allotment in the initial public offer. For founders, their minimum statutory contribution is locked in for 18 months and the amounts in excess of that are locked in for six months. If the majority of the issue proceeds, excluding the portion of offer for sale, and is proposed to be utilised for capital expenditure, then the lock-in period for the promoter contribution is 36 months from the date of allotment in the initial public offer.
New Advances in Private Equity and Venture Capital Investments in India
India has established itself as one of the largest hubs for start-ups, with a thriving ecosystem comprising of private equity and venture capital investors, incubators and various intermediaries. Indian start-ups received a large share of global private equity and venture capital investments, and the volumes and size of such investments are only expected to increase. This paper aims to highlight the trends in the PE/VC sector and some of the key issues faced by private equity and venture capital investors and startups in structuring investments in India.
Recent Investment Trends in India
India has become a promising destination for private equity and venture capital investments, and Indian start-ups attracted an investment of USD24 billion from global investors in 2022. The start-ups have gained recognition as legitimate business entities that have the potential to disrupt the market dynamics and compete with traditional business houses. With their innovative product offerings, contemporary methods for talent retention, like liberal ESOPs (employee stock ownership plans), flat management structures and opportunities for growth, the start-ups are able to not only gain market share, but attract talent in the rapidly evolving and dynamic Indian economy.
As of May 31, 2023, India produced a total of 108 unicorns with a combined valuation of USD340 billion and is third largest hub for start-ups. In 2021 alone, a total of 44 new unicorns were established, resulting in a combined valuation of USD93 billion. As of May 31, 2023, out of 56 decacorns globally, 4 decacorns are operating in India (i.e., Flipkart, BYJU's, Nykaa, and Swiggy). In 2022, the venture capital firms made a collective investment of USD46 billion in the Indian market and as of first half of 2023, a total of 568 venture capital funding deals have been announced with a combined value of USD3.7 billion.
The prominent sectors that attracted the maximum PE/VC investments are fintech, edu-tech, food technology, logistics, supply chain, media and entertainment, direct-to-consumer brands (D2C), SaaS, and health-tech.
Vibrant ecosystem and ease of business
The Indian start-up ecosystem is well supported by a large number of incubators, accelerators professionals and intermediaries. There has been a notable rise in the number of incubators in tandem with the flourishing Indian start-up space. India currently has more than 400 incubators and accelerators that have played a pivotal role in supporting start-ups in their early stages by honing the entrepreneurial skills of the founders; providing critical support, guidance and resources to start-ups, and helping them raise seed funding.
The Indian government has also implemented various measures to enhance India’s reputation as an attractive destination for investment. The Indian government increased foreign equity caps for the insurance and defence sectors, introduced flexibility in labour law compliances, implemented a uniform goods and service tax across all states, and streamlined numerous corporate filings and compliance requirements. All these measures are expected to improve the overall business environment in India and will be helpful for start-ups and private equity and venture capital funds to operate in India.
Global trends and impact on the Indian market
Last year had been particularly challenging for global economies. The business world is recovering from epidemic, regional instability and war between Ukraine and Russia, high inflation and rising interest rates, and fears of global recession - all of which have contributed to a ‘funding winter’ across the world.
Despite the macro-economic headwinds on the global front, the Indian economy showed resilience. From the standpoint of macro-economic parameters, India had been relatively immune to the above concerns and performed better than other economies. Indian GDP is expected to grow at a reasonably high rate of 6-7%. India did not face a substantial hike in interest rates or inflation, and there is no fear of recession in India. India is also likely to benefit from the "China Plus One" strategy adopted by large multinational corporations to diversify their production and supply chain activities. While Apple has already implemented the plans for sourcing of the iPhone from India, Tesla is in the process of finalising its plans for setting up a plant in India.
Key considerations for investors in the Indian startup ecosystem
With positive macroeconomic conditions, a large market and demographic advantage in terms of having a young population, India has tailwinds supporting growth and attracting investments from global investors. However, there are still several challenges that global investors face while investing in Indian start-ups. Global investors have to navigate through a complex regulatory framework, create lots of filings and paperwork, face issues in enforcement of contracts, and seek structured solutions to protect their investments and exits. Furthermore, with the funding winter, investors have become cautious and conservative, and are seeking better contractual rights to protect the value of their investment, which has added to the complexity in deal making in India.
Timely deal closures
Due to the cautious approach adopted by most of the investors, transactions are taking a longer time to close. The funding winter has caused valuations to dip globally, which has led to a wider gap in the valuations expected by the founders and those offered by the investors. Such a gap in commercial valuation of start-ups means heavy negotiations, more protective provisions and greater time in consummation of the transactions.
With the onset of the funding winter, investors are seeking better rights to protect the return of their investment and value. Instead of the standard provisions for liquidation preference, which typically used to be equivalent to the investment amount or pro rata entitlement of liquidations proceeds (as per the shareholding), investors are proposing more complex formulae and conditions for distribution of the liquidation proceeds and are seeking higher preference and returns. Furthermore, investors are seeking better investor protection matters or veto matters that will necessarily require consent of the investors, especially around protection of value of the company at the time of exit by the investors. As a consequence, the complexity of the transactions is increasing and there is delay in deal closures.
Down rounds and anti-dilution valuation protection
At the time when funds were easily available, a lot of start-ups had adopted business models with high cash burn rates, made expensive acquisitions or taken venture debt at high rates in anticipation of raising funds from private equity investors. With the onset of the funding winter and difficulty in raising funds, various start-ups have undertaken down-round financing (ie, funding at a valuation of the company that is lower than the previous financing round). Such down rounds triggered the anti-dilution valuation protection rights for existing investors. The anti-dilution provisions provide existing investors an adjustment to their entry price by adjusting the conversion rate of their preference shares into equity shares so that the existing investors are not impacted by the down-round financing after their investment.
India does not have full capital account convertibility and Indian startups may face challenges in fully implementing the agreed anti-dilution provisions for the benefit of existing investors. Under the foreign exchange laws of India, the conversion price of the shares cannot be lower than the fair market value (FMV) prevailing at the time of investment by the existing investors. Thus, unless there was a wide gap between the FMV of shares and the issue price of shares to existing investors, it may not be possible to adjust the conversion price of shares to lower than the FMV of shares at the time of investment by existing investors. Also, there is no clarity whether the parties are required to inform the Reserve Bank of India (RBI) (the central bank of India) upon adjustment of the conversion price or issuance of additional anti-dilution shares to the existing investors.
The implementation of anti-dilution provisions is also likely to get more complex with the recent amendments to the angel tax regime. The angel tax provisions propose to tax any amount received by a company that exceeds the FMV of shares. Thus, while the implementation of anti-dilution provisions under foreign exchange laws is only possible if the issue price of shares is higher than the FMV of shares, the angel tax provisions will make implementation of such provisions costly by taxing the difference in issue price and FMV of shares in the hands of the startup.
It is widely perceived that the angel tax provisions would make the implementation of anti-dilution provisions difficult and that private equity investors are likely to discount the valuation of Indian startups as they will perceive higher risk in Indian investments.
The present funding winter has presented considerable challenges for start-ups to obtain the necessary funds for their operations, and is leading to industry consolidation. Smaller companies that have high cash burn rate or are facing challenges in raising funds are increasingly attracting attention from established start-ups looking for inorganic growth. Some of the notable consolidation transactions include Zomato's acquisition of Blinkit, BYJU's acquisition of Northwest Executive Education, upGrad acquisition of INSOFE and College Dekho acquisition of GetMyUni and PrepBytes. This phenomenon is particularly noticeable in industries such as fintech and edu-tech, where organisations frequently aim to gain a competitive advantage despite offering similar products or services.
Often, such consolidation of the business of two enterprises is implemented either through a merger or a share swap arrangement. Share swaps in India have tax implications in the hands of transferor. Even if the shares are transferred without a cash consideration, the seller may be liable for tax on such a transfer. Also, the transferee of shares may be required to withhold taxes prior to implementing the share swap, even in an all non-cash transaction, if such shares are being acquired from a non-resident transferor.
On the other hand, the merger or business transfer may be more tax efficient in case of non-cash share swap deals. However, the mergers in India are required to be implemented through a court approved process. The court (ie, the company law tribunals) may take up to 9 to 12 months to approve a merger and such a merger may also be subject to an incidence of stamp duty. Typically, the parties in such mergers involving a share swap enter into complex agreements that govern their relationship during the time involved in seeking the approval of court for the merger.
Exit through IPOs
2022 was not a satisfactory year for initial public offerings (IPOs) by tech companies due to the prevailing funding challenges and global macroeconomic uncertainties. In India, the tech start-ups that were listed on the stock exchanges experienced a significant decline in their valuations, prompting several unlisted start-ups to abandon their plans for going public.
In 2022, a total of three Indian start-ups successfully conducted their initial public offerings (IPOs). These companies include Delhivery, Tracxn, and DroneAcharya. However, eight start-ups, namely Droom, Snapdeal, PharmEasy, MobiKwik, and OYO, submitted their draft red herring prospectus (DRHP) in 2021 with the intention of going public in 2022. However, these plans have been either abandoned, the DRHP has been withdrawn, or they are still awaiting approval from the Securities and Exchange Board of India (SEBI).
In contrast, a total of 11 start-ups successfully completed initial public offerings (IPOs) in the year 2021. Notable examples include Zomato, Paytm, Policybazaar, EaseMyTrip, and Nykaa. Nevertheless, a significant number of these start-ups have witnessed a notable decrease in their stock prices, ranging from 25% to 75%, subsequent to their initial listing on the stock exchanges.
The prevailing negative sentiment surrounding the above-mentioned start-ups in 2022 may potentially influence unlisted start-ups considering public listing in 2023 to pursue more conservative and realistic valuations and exit mechanisms. Conversely, those unwilling to compromise on valuations may find themselves compelled to postpone their IPO plans.
Further, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, provides lock-in requirements for promoter shareholding to the extent of 20% of the post issue capital, for a period of 18 months from the date of allotment in the initial public offering/further public offering. The lock-in requirement for pre-IPO stocks held by non-promoter shareholders is 6 months. The law provides for lock-in conditions on promoter shareholding to ensure that the promoters maintain ‘skin in the game' and do not leave the company upon receipt of the IPO funds. Over time, the traditional ownership structure of Indian companies, which was previously dominated by promoters, has been rapidly replaced by institutional investors such as private equity firms, alternative investment funds, and so on, who stay invested in the company for a significant number of years before the company goes public. However, the lock-in requirements continue to apply to all such pre-IPO investors, who may have to be locked in even after listing of the companies over the stock exchange and bear the risk of price fluctuations at the time of actual exit.
Routing of investments through tax friendly jurisdictions
Private equity investors sometime like to route the funds through tax friendly jurisdictions, which may sometime not be Financial Action Task Force (FATF) compliant jurisdictions. The RBI has restricted investments in non-banking finance companies (NBFC) by investors from FATF non-compliant jurisdictions. The investors from or through FATF non-compliant jurisdictions will be barred from acquiring 'significant influence' in investee NBFCs as well as firms seeking certification of registration. The term 'significant influence' refers to possessing more than 20% of actual and potential voting power. As a result, investors from non-FATF-compliant jurisdictions are prohibited from acquiring more than 20% of voting rights in NBFCs.
There are many start-ups who are involved in activities and business which are regulated by a financial sector regulator such as the Insurance Regulatory and Development Authority of India (IRDAI) and the RBI. The sectoral regulators, while giving licenses and permissions to these start-ups to carry out a regulated activity, strictly scrutinise the shareholding pattern of these companies and undertake due diligence on the shareholders or management that are likely to have significant influence on such companies. The regulators may seek more explanations or clarifications if such startup has investors from FATF non-compliant jurisdictions, even if the investment by such investors is less than the 20% threshold. The private equity investors shall, therefore, give due regard to such aspects prior to routing their investments in India and, if the startup is likely to engage in regulated activities, private equity investors may avoid FATF non-compliant jurisdictions, even if such jurisdictions provide tax advantages.
Restraint on round tripping
While the Indian startup ecosystem remains robust, with consistent investment growth and a resilient economy, sometimes it is seen that the start-ups are owned through holding companies that are established outside India. Such holding companies then acquire or establish an operating company in India as a wholly owned subsidiary.
Until August 22, 2022 such structures were not permitted, and an Indian resident or Indian company was not permitted to invest in either a foreign holding company which would invest back into a company in India, or one that already has investments in India. Such structures used to be regarded as ‘round-tripping’ or ‘ODI-FDI’ structures, which were prohibited until August 2022. The RBI used to be of the view that such structures were being employed by Indian corporations to evade taxes and/or for money laundering activities. This restriction had the impact of limiting the fund-raising options for the start-ups, and Indian corporates were constrained of choice of investors and jurisdictions in which to operate.
However, recently the Central Government and the RBI have introduced revised foreign exchange overseas investment regulations and rules. Under the new regime, round tripping structures are permitted. An Indian company/LLP may invest in a foreign entity and such foreign entity may invest in India, as long as the resulting structure does not have more than two layers of subsidiaries.
Although under the new regime for overseas investment the exact meaning of “two layers of subsidiaries” needs some more clarification, it can still be said that the liberalised regime in relation to ODI-FDI structures is a progressive step that will facilitate transactions that were otherwise unintentionally impacted by the old regime's broad-based application of an inchoate round-tripping restriction.
With a population of over a billion and a rapidly growing middle class, India offers a vast and diverse consumer base that is both a source of market opportunity and a testing ground for innovative products and services. Moreover, India's demographic features, including a young population and a growing pool of skilled talent, provide a distinct advantage in terms of human capital. Investors are starting to explore the opportunities in the Indian market, with widened focus on sectors like manufacturing and tech that are anticipated to benefit from the expanding domestic consumption. A high level of consolidation has already started taking place, with well-established startups trying to grow inorganically. Also, many large corporates are looking to acquire startups to increase their e-commerce and technology capabilities.
The business environment in India, while presenting its own set of challenges, has progressively evolved to become more conducive to entrepreneurial ventures. Government initiatives aimed at promoting ease of doing business, coupled with regulatory reforms and digital transformation efforts, have created an environment that encourages investment and fosters collaboration between start-ups and established businesses.