Inbound private M&A deals – value protection

By Nikhil Narayanan, Amarchand Mangaldas
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Although international investors are often aware of the need to carefully structure investments into India, issues that affect value sometimes come as a surprise. These are summarized below.

Transfer pricing traps: Unless an international investor is an “associated enterprise” under section 92A of the Income Tax Act, 1961, its acquisition of an interest in an Indian target will not be subject to the arm’s length valuation rules. However, investors need to exercise care in relation to any previous documentation, such as letters of intent prior to the sale and purchase agreement, where their affiliates execute the transfers, as these have the potential to result in the application of the transfer pricing rules.

Nikhil Narayanan
Nikhil Narayanan

Difficulties in enforcing recoveries: Although deal protection provisions feature in Indian agreements, the enforcement of warranties, indemnities, guarantees and retention arrangements in favour of an international investor will require the approval of the Reserve Bank of India (RBI). The limited escrow exemption in the public context will not apply to private transactions.

The RBI may well approve payment when presented with a judicial award, but the lack of certainty is a concern and investors sometimes approach the RBI for advance approval. However, parties do not always do so due to timing concerns and the risk of the imposition of caps by the RBI.

Various contractual solutions have also evolved, although they only work in particular contexts. These include payments outside India or under separate contracts, “hold-back” and convertible instrument structures (see below), the over-acquisition of shares at the outset by the investor with subsequent dilution if there are no claims, and the contribution of cash to the company by the majority shareholder to compensate for the reduction of value in its shares on a breach of warranty (assuming the seller remains a shareholder).

An alternative to the classic approach of valuing the shares fully on the basis of the warranties being true and then recovering for a reduction of value if warranties are breached is to price in all potential risk (i.e. a distressed M&A approach). However, this will be unattractive to sellers and is unlikely to be a practical solution in many cases.

Earn-outs and price adjustment mechanisms: The payment of any deferred consideration will require the approval of the RBI, which affects earn-outs and upward purchase price adjustments.

Contractual solutions include the “hold-back” structure (where the purchaser holds back part of its acquisition until a later date) and the issuance of convertible instruments, where differential pricing/conversion rights effectively achieve the earn-out or adjustment.

These approaches have limitations, but there are few alternatives. Locked box structures are rare in India. In any event, such structures put pressure on the purchaser’s financial diligence and its value leakage protections which may not always be feasible in the Indian context.

Downside protection: Investors have struggled to achieve complete downside protection in India. Debt instruments and preference shares must be compulsorily convertible into equity to avoid being treated as debt (which is undesirable from a regulatory perspective). In response, investors have attempted to de-risk their investments through put options to achieve exits at desired target values, although this has been the subject of regulatory uncertainty.

The Securities and Exchange Board of India in October 2013 clarified prospectively that such options do not constitute derivative instruments and the remaining issue was in relation to the RBI’s approach. The RBI attempted to put an end to these concerns in a notification in January 2014 permitting put options subject to certain conditions. However, many of the conditions (e.g. pricing/exit value-related restrictions) are unhelpful to investors. Crucially, the RBI has unequivocally stated that its move is not intended to permit any assured returns, which negates the key de-risking objective of this mechanism for investors.

Equity kickers: The equity upside of structured investments has traditionally been achieved by converting convertible instruments into ordinary shares. In this regard, the Finance Act, 2014, has increased the holding period for long-term capital gains treatment (which has a beneficial rate) in relation to the sale of unlisted securities from one to three years. The Income Tax Act has not historically explicitly included “pre-conversion holdings” in this qualification period, so this change has the potential to impact returns.

Warrants in the context of unlisted companies have historically been the subject of regulatory ambiguity. However, in July 2014 the RBI published a notification permitting such instruments provided that the pricing formula is determined and 25% of the consideration is paid at the outset, with the remainder being paid within 18 months. This is a welcome change.

Takeways: India remains a challenging environment for M&A transactions despite recent changes. International investors need to structure carefully but may not always be able to fully achieve their desired protections.

Nikhil Narayanan is a partner at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the author and do not reflect the position of the firm.

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