Will a new regulator and a more favourable tax regime succeed in stimulating the private equity sector?

Emerging markets are still an attractive playground for private equity (PE) players. Over the past decade, PE firms saw India as a destination of choice, even as economic growth slowed, the stock markets remained choppy, and the Indian rupee depreciated. “The past few years of economic uncertainty has ended private equity’s golden age of huge internal rate of returns,” says Shardul Shroff, the managing partner at Amarchand Mangaldas in New Delhi.

Quieter bets

As a result, big-ticket deals have been pushed out of the window. Private equity firms invested about US$1.9 billion across 90 deals during the quarter that ended on 31 March, according to a study by Chennai-based Venture Intelligence, which focuses on private equity and M&A activity in the country. The investment amount was just over half of the US$3.6 billion spent in the same period last year across 107 transactions.

“This is the third consecutive quarter of deceleration in PE investments in India,” says Arun Natarajan, head of the research firm. The loss of momentum is evident in the shrinking size of deals. There was not a single deal above US$200 million, compared with five in the corresponding period last year. “It’s a sign that investors were not willing to take big risks,” says H Jayesh, the founder partner of Juris Corp.

Arun Natarajan Head Venture Intelligence

There were 454 PE deals totalling US$9.4 billion in 2011, a 12% increase in total value over the previous year. The most significant was private equity major Apax Partners backing Nasdaq-listed iGate to acquire Indian software services provider Patni Computer Systems. Apax shelled out US$921 million for a 63% stake in Patni and also invested US$480 million in iGate, making it the largest deal in India’s IT and IT-enabled services sector.

Another major deal was the US$848 million funding of the New Delhi-based Hero Group by Bain Capital and Government of Singapore Investment Corporation (GIC) to buy out Japanese automaker Honda Motors’ 26% stake in the Indian joint venture Hero Honda.

New focus: E-commerce and healthcare

In the formerly favoured infrastructure sector, the lack of reforms has driven investors away, while increased consumer spending has thrown up new consumer-driven investment opportunities for PE and venture capital firms. Venture capitalists say they are keenly eyeing over 50 e-commerce sites that are jockeying for customers’ eyeball time. And investment bankers say over US$2 billion will flow into the healthcare sector this year. The first quarter of 2012 has already seen US$581 million across 14 healthcare investments. These include Advent International’s US$110 million investment in Care Hospitals, GIC’s US$100 million funding for Vasan Healthcare and Temasek’s investment in Godrej Consumer Products.

However, such investments are not seen as signs of a private equity bull run. “Current deal-making in India is still robust but valuations are depressed,” says Vikram Utamsingh, head of transactions and restructuring and private equity advisory at KPMG in India. A lot of this is to do with uncertainty regarding some new laws and regulations by the government and the Securities and Exchange Board of India (SEBI) relating to financial sponsorship.

Vikram Utamsingh Head, Transactions and Restructuring Private Equity Advisory KPMG

The ghost of Vodafone

As expected, India’s annual budget in March addressed the Supreme Court’s landmark ruling in January in the Vodafone case. The decision embarrassed the Indian government: India’s tax authorities lost a bid to levy more than US$2 billion in tax on British telecom player Vodafone for acquiring a 67% stake in Hutchison Whampoa’s Indian mobile phone unit for US$11 billion in 2007.

The court upheld the appeal of the rechristened Vodafone Essar, saying that the tax authorities had no jurisdiction over the Vodafone deal. The court also told the Indian tax department to return US$500 million, which Vodafone had deposited, along with 4% interest.

In the budget, the government announced that it would introduce a retrospective amendment to tax cross-border deals involving Indian assets, like the Vodafone deal, which was routed through the Cayman Islands, a jurisdiction that does not have a double taxation avoidance agreement (DTAA) with India.

Fears have emerged that the tax authorities may scrutinize other transnational deals like Vodafone. These include deals such as Vedanta’s acquisition of Mitsui’s 51% stake in Sesa Goa for US$981 million, or General Atlantic and Oak Hill Partners’ 2004 purchase of General Electric’s 60% stake in business process management outfit Genpact.

On 7 May, finance minister Pranab Mukerjee clarified that the retrospective tax would not apply to deals routed through countries with which India has a DTAA: “I would like to be guided either by a double tax avoidance agreement or domestic tax law,” said Mukherjee. “There cannot be a situation where somebody will make money on an asset located in India and will not pay tax either in India or to the country of its origin.”

The government defended its right to tax overseas transactions of companies that realize capital gains from the sale of their Indian assets but deferred implementation of its proposed general anti-avoidance rules (GAAR) from 1 April this year to 1 April 2013.

India’s finance ministry also said it would slash its long-term capital gains tax rate on sales of unlisted securities by private equity and venture capital investors from 20% to 10%, putting them on par with foreign institutional investors (FIIs).

Island envy: the tax battle continues

Meanwhile, Vodafone has threatened to drag Manmohan Singh’s government to international arbitration over the tax issue, and the move to tax deals that take place outside of India is seen as a big blow to the private equity industry and FIIs in India.

Escape routes: Analysts say there are over 500 private equity funds waiting to exit their investments in India.
Escape routes: Analysts say there are over 500 private equity funds waiting to exit their investments in India.

Private equity investments in India are typically routed through Mauritius, a country that has a DTAA with India. The pact means that companies which are based in Mauritius are exempted from paying tax on the sale of Indian shares of listed or unlisted companies. FIIs too, have flown in from no tax and low tax destinations that have no DTAA with India, such as the Cayman Islands and the British Virgin Islands.

Finance ministry officials say that the government has suffered an annual revenue loss of US$600 million due to such routing. Bankers say that 40% of India’s foreign direct investment (FDI) between 2000 and February 2012 was routed through Mauritius. (For an analysis of the Mauritius legal market, see page 39).

Pacifying the funds

The government’s recent tax moves have caused considerable disquiet among PE and VC investors. “It is very important for the private equity and venture capital community that we have a stable, long-term, clear tax policy from the government,” says Sumir Chadha, co-founder and managing director of WestBridge Delaware Advisors. “This is crucial as funds typically commit capital for 10 years, and changing tax rules in the middle of a fund creates a lot of uncertainty, making India less attractive as an investment destination for PE and VC.”

Sumir Chadha Co-founder and Managing Director WestBridge Delaware Advisors

David Jacobs, a partner and head of the global India initiative at the Sydney office of Baker & McKenzie says: “The proposed retrospective tax regulation is causing considerable anxiety among most of our clients.”

David Jacobs Partner and Head, Global India Initiative Baker & McKenzie

Investors may be satisfied for the time being with the delay in enforcing GAAR and the reduction on long-term capital gains. Sandeep Parekh, founder of Mumbai-based law firm Finsec Law Advisors, says: “The partial rollback of some provisions and also the postponement of GAAR are welcome steps as they negative the negative news of the past few months.” He adds that while there may not be a burst of interest from investors based on these developments, “at least investors who had become hugely disappointed with the investment outlook in India would sigh with relief”.

The government’s bid to rein in investors is not surprising, some lawyers say. Anand Desai, the managing partner at DSK Legal, believes that some practices are either not noticed or are considered acceptable until a very large number of transactions occur. “Once it builds up to a crescendo, then things are changed, sometimes with retrospective effect,” he says.

‘Big boss’ moves in

In another significant move, the 10-year-old private equity industry is to be regulated by the Securities and Exchange Board of India (SEBI), which earlier monitored only listed companies. On 2 April, the regulator approved the proposal to frame rules governing alternative investment funds (AIFs), which will require all AIFs including PE funds, venture capital funds, real estate funds and hedge funds to be registered.

“SEBI’s primary objective of seeking to regulate private pools of capital in India is to provide safeguards to investors, and create a facilitative environment for fund managers,” says Vandana Shroff, a partner at Amarchand Mangaldas’ Mumbai office.

Private equity players such as WestBridge Delaware Advisors believe that the AIF regulations could be positive, but it all depends on their final form. “I support part of the thrust of AIF, which is to create categories such as venture capital funds, in order to give them special incentives,” says Chadha at WestBridge. “However, the risk is that too much control and paperwork can make it difficult for the PE industry.”

Vandana Shroff adds that “the level of regulation contemplated under the draft AIF regulations may prove to be cumbersome for fund managers, investors and the private equity and fund industry.

Vandana Shroff Partner Amarchand Mangaldas

Others are more optimistic “There are issues around governance in terms of policy-making, regulation and taxation,” said Niten Malhan, the managing director of Warburg Pincus in India, speaking at the India Private Equity and Venture Capital Association (IVCA) Conclave 2012 held in New Delhi in April. “Our view is that these issues will hopefully get sorted. I don’t think there are any long-term problems,”

Seed Fund’s managing partner Pravin Gandhi believes that after the initial brouhaha concerning the regulations peters out, the government may roll back some of its initiatives.

Eager to exit

While the industry grapples with the uncertainty in the regulations, the queue in the anaemic exit markets is growing. Venture Intelligence’s Natarajan says over 500 exits are in the offing, as most of the 2005-06 investments are coming to fruition. Typically, private equity players get antsy about their investments after five to seven years, and want a way out. An excerpt of Bain & Co’s 2012 report on India Private Equity, in collaboration with the IVCA, published in Mint recently, said that there was a 30% drop in the number of exits in 2011 over 2010.

“Exits for private equity funds are still subject to several challenges,” says Anil Kasturi, a partner in the M&A and PE practice at AZB & Partners in New Delhi. “There is still a high level of dependence on exits through an IPO, severely restricting the ability of investors to realize the full value of investment in a falling market.”

Anil Kasturi Partner AZB & Partners

After a reasonably good year for private equity players in 2011, the markets have slid 21% since the January 2011 high of over 20,000 points, making exits tough for players. There were just four PE-led IPOs in the 2011 calendar year and one – MCX – in the first quarter of this year, according to Venture Intelligence. That’s because many PE players invested at premium valuations around 2006 to remain competitive, says the head of a leading foreign private equity firm.

Raghubir Menon, a partner at Amarchand Mangaldas believes that with growing uncertainty in the global market and a flexible Indian economy, Indian PE firms are changing the way they approach their investments. “A successful exit will often depend on the state of the capital markets,” he says. “With high inflation and a global debt crisis, exits through IPOs and public market sales may not be preferred. PE investors must therefore, look for other exit options.”

Anuradha Iyer, a partner at I&S Associates, notes that “one of the biggest challenges facing the sector is the high entry point valuation against the low value on exits, given the economic scenario and failure to meet performance benchmarks”.

Anuradha Iyer Partner I&S Associates

A new exit route?

At the moment, the preferred route seems to be strategic sales, which is selling to another PE firm. There were 72 strategic sales last year and this year has seen 29 to date. “Coming to a PE allows you to get another round of funding and gives you additional time for an IPO in the future,” says Utamsingh at KPMG.

But complications could arise here too. The Reserve Bank of India (RBI) has taken the view that “put options” (or the right to require a promoter to buy back shares at a pre-agreed price) may not be legally valid. “With the RBI taking a strict stand on put options or the tax authorities ruling that a pre-agreed buyback of shares may constitute deemed dividend, PE investors are now having to consider alternative modes of exit. In the RBI’s opinion a sellback right or a put option to foreign investors will amount to being a one-to-one derivative deal,” explains Menon.

The confusion was further compounded when the Department of Industrial Policy and Promotion announced through its FDI policy released in late 2011 that all equity instruments issued or transferred to non-residents that had built-in options or were supported by options would lose their equity character and would be treated as debt. “This was thankfully withdrawn, but the RBI is yet to change its views,” says Kasturi at AZB.

Until there is more clarity on the regulations, private equity in India may enter a state of flux. As Iyer says, “The whole game for PE funds has changed.”