N Raja Sujith at Majmudar & Partners analyses the entry and exit hurdles facing private equity investments
Regulatory hurdles in India have been always a challenge for private equity (PE) investors. However, the flow of PE investment into India has been quite steady in the past, despite several ambiguities in the legal regime governing such investments.
Until 2007, a popular instrument used for PE investment was convertible preference shares. However, since May 2007, preference shares with a partial or non-conversion option have been treated as external commercial borrowings (ECBs), which require onerous approvals. PE investors now have the opportunity to structure their investments through fully and mandatorily convertible preference shares, debentures or equity shares, instead of partly or non-convertible preference shares.
Some regulations relating to PE investments in listed companies are ambiguous. When PE investors acquire rights in listed companies (such as veto rights on key management decisions), they may be held to have acquired “control” over the company, thereby triggering open offer requirements as specified under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.
The Subhkam Ventures case clarified that veto rights acquired by a financial investor in an investee company cannot be construed as a controlling stake. However, India’s Supreme Court left open the position of law in this regard and stated that the Subhkam Ventures case should not be treated as a precedent. In this context, PE investors must structure their investment agreements to minimize the chances of those investments being construed as giving them control over the investee company.
Deal-making by PE investors may get tougher because of a proposed rule under the Finance Bill, 2012, which requires companies to pay income tax on the premium they have charged over their fair market value while selling shares to unregistered investors, including PE or venture funds. However, the government has yet to specify how the fair market value will be calculated, which is likely to be the biggest bone of contention.
The introduction of a retrospective tax in the Finance Bill on the indirect transfer of a controlling interest in an Indian company could increase transaction costs for PE investors. As a result, investors will have to rethink their strategies while exiting the investee company. Furthermore, when implemented, the new general anti-avoidance rules (GAAR) will impact deal-making by foreign PE investors as the tax department may refuse to grant them favourable treaty benefits. The good news is that GAAR will be now applicable from the next financial year (2013-14).
Finding a way out
Exit options are of utmost importance while negotiating PE investment deals. PE investors face a variety of regulatory hurdles while exiting an investee company.
One of the most popular exit routes is through an initial public offering. However, due to the recent slump in the capital markets, PE investors are looking at alternative exit routes, such as strategic sales, buybacks or redemption of shares, put options on promoters, drag-along and tag-along rights, and M&A. These exit routes also suffer from regulatory ambiguities.
In a strategic sale, exit valuations are restricted by valuation guidelines issued by the Reserve Bank of India. If an investee company is listed at the time of exit, a non-resident PE investor cannot exit at a price that is higher than the price at which a preferential allotment of shares can be made under SEBI regulations. If an investee company is unlisted at the time of exit, the shares are to be valued through a discounted cash flow method. The valuation restriction is not applicable to a foreign venture capital investor registered with SEBI.
PE investors normally resort to enforcing their put options on promoters to exit their investments. However, due to confusion created by the regulators and the judiciary, PE investors are hesitant to use put options as an exit mode. PE investors can use in-built options such as put or call, or pre-agreed buyback options in their investment agreements with private companies. However, PE investors should exercise caution while structuring their exits keeping in mind the regulatory uncertainties.
PE investors frequently use the right-of-first-offer, right-of-first-refusal and drag and tag-along rights to exit an investee company. The enforceability of pre-emptive rights has been viewed as a hindrance to the principle of free transferability of shares of a public limited company as laid down in section 111A of the Companies Act, 1956. However, recent judicial pronouncements indicate that PE investors may use these pre-emptive rights.
Buybacks by investee companies are also a popular exit route among PE investors. Here, regulatory roadblocks include the permissible limit of buyback in a year (i.e. 25% of the free reserves and paid-up capital of the company). However, PE investors that can exit in a phased manner could exit in this way.
Creating a PE regime
Many of these hurdles ultimately highlight a single structural problem: the lack of a special regime regulating PE investors in India. SEBI has approved a proposal to frame alternative investment fund (AIF) regulations to govern various AIFs, including PE funds. The proposed regulations may help to create a special regime for PE investors. To achieve this goal, regulators will have to take adequate steps to remove ambiguities and smooth PE entry and exit paths.
N Raja Sujith is a partner at Majmudar & Partners in Bangalore. He can be contacted at email@example.com. The views expressed in this article are personal and do not reflect the official position of the firm.