Economic growth at the rate of 6% or more is an imperative for financial stability of the economy but in a scenario of stagflation it is an uphill task for the financial leadership of the country. Private Equity with its dedicated time bound investment model holds tremendous potential for the desired growth. But latest tax proposals with retrospectivity as their mainstay have soured the investment climate. Lex Witness bureau explores the promise…
A country which aspires to catch up with the developed countries requires loads of capital to pump into its economy and people to do so. And for the achievement of that outstanding economic growth all sorts of capital, except dirty capital is welcome. In that regard Private Equity (PE) serves as a life saver for capital constrained developing economies, as it helps to bridge large saving investment gaps. The Bain and Company in its “India Private Equity Report 2011” highlights the factors which will continue to attract Foreign PE funds to the country stating that though rising interest rates and sustained pressure on corporate earnings yet the investment opportunities look attractive both in short and long term as the consumer spending continues to increase on the back of rising disposable household incomes. The government remains committed to its goal to close India’s infrastructure gap and keeps pursuing its growth and reform agenda in key sectors like financial services and energy, among others. At the current rate of GDP growth, the total value of goods and services produced by India’s economy should approach US$1.3 trillion by the end of the year. Despite a long history, the penetration of PE capital into India remains a miniscule 0.61 per cent of GDP today.
In general what will be the impact of Private Equity deals in the country post budget 2012 scenario?
The Budget 2012 has raised multiple issues to be considered by an Overseas Private Equity Fund which are India focused. Generally, a PE Fund chooses jurisdictions like Singapore, Mauritius or Cyprus to set up its feeder fund and investment vehicle for investing in India. The key objective of setting up a fund in above mentioned jurisdiction was to offer a funnel to consolidate investors commitment, have an ease for future entry / exit and to avail a beneficial provisions under the respective tax treaty. However, by introduction of General Anti-AvoidanceRules (GAAR) and covering transfer of shares, directly or indirectly, of an overseas company deriving value substantially from the assets located in India under the tax net, setting up of overseas Private Equity Fund will face certain challenges.
What legal structure(s) are most commonly used as a vehicle for private equity funds in India? Are these structures taxed, tax exempt or fiscally transparent for domestic and foreign investors?
The legal entity structured as a feeder fund is a company limited by shares (like a private limited company in India). Such an entity could be set up as a limited life company. Such entity invest in India either directly or through step down subsidiary company under the FDI guidelines of India. The taxation of such entity depends on the jurisdiction where they are set. For example, if such an entity is set up in Mauritius, then it will be registered as a Global Business License 1 (GBL1). A GBL1 company is subject to tax in Mauritius at 15 percent. Mauritius offers deemed credit on the foreign sourced income and exempt capital gains from local taxation. A domestic Indian investor does not invest in an overseas fund, which inturn invests in India. This could be considered as a round-tripping of funds. However, for foreign investors, depending on the jurisdiction in which the fund entity is set up, their home country tax authorities may consider investment in fund entity either as a pass-through or as a taxable entity.
What (if any) structures commonly used for private equity funds in other jurisdictions are regarded in India as not being tax transparent (in so far as they invest in Indian companies? What parallel domestic structures are typically used in these circumstances?
In developed jurisdictions like US and European region, a private equity fund is generally set up as a limited liability partnership (LLP) and is considered as a pass-through for home taxation. On the other hand, an India focused overseas PE fund is set up as a company for ease in availing tax treaty benefits in India and to overcome any litigation on eligibility of tax treaty benefit for an overseas LLP.
The most common structureused to raise a domestic fund is Venture Capital Fund (VCF) / Venture Capital Company (VCC) registered with SEBI under the prescribed guidelines. The Budget 2012 has proposed to restored the tax treatment of a VCF/VCC back to pre2007 treatment under the Act with some amendments. This is a welcome move and will offer clarity of taxation for VCF / VCC. There are certain technical issues related to withholding tax obligations which need to be addressed by such fund on upstreaming the income / funds to its investors.
It was pre-reform India when the seeds of Private Equity were sown in India, i.e. precisely in 1984 ICICI set up its venture capital wing ‘Technology Development and Information Company Ltd’ to encourage start-up ventures in the private sector and emerging technology sectors and IFCI sponsored ‘Risk Capital and Technology Finance Corporation of India Ltd’, these funds later graduated into indigenous private equity firms by broadening their sphere of activities. Between 1995-2000, several foreign PE firms like Baring PE partners, CDC Capital, Draper International,HSBC Private Equity and WarbugPincus also started coming in. Firms like Chrys Capital and West Bridge Capital set up by managers of Indian origin with foreign capital also embarked into India with a focus on IT and internet related investments in tune with the technology boom in US during the period (Venture Intelligence, 2005). But all said and done despite a long history, the penetration of PE capital into India remains a miniscule 0.61 per cent of GDP today.
We all know that first and foremost the business is all about profits and the profits are directly proportional to the amount of risk taken. And in that regard PE funds take considerable risks by investing in illiquid assets and like Maggi Sauce “it’s different” in the sense that they are entrepreneurs’ entrepreneur which specialize in the business of pooling funds from institutional investors and high net worth individuals styling themselves as trusts, partnerships to channelise capital and know how to unlisted start-up companies through buying of majority stake orpartial/complete buyout of growth promising firms. The usual life cycle of their investment is 3 to 5 years between their entry and exit. The PE funds act as an active partner with the company they have invested in and focus on value enhancement of the investee through financial and technical support.
In general what will be the impact of Private Equity deals in the country post budget 2012 scenario?
Overall, the budget proposals of 2012 are likely to have a negative impact on the private equity deals in India. Largely, it would be due to the tax treatment of such investments.
The current budget proposals require firms to pay income tax on the premium they have charged over their fair market value, while selling shares to unregistered investors, including private equity and venture capital funds. Sale of shares to investors who are registered with the Securities & Exchanges Board of India (SEBI) as domestic venture capital funds (including private equity funds) are, however, exempt from this. Since a large majority of private equity players are not registered with SEBI, this will make it difficult for them to invest in Indian companies.
Usually, sale of shares to the investors is done at premium to the fair market value. The extant regulations allow companies to determine the fair market value at their book value, while the premium could depend on numberof other factors e.g. the cash flow availability, market conditions etc. The new draft provisions indicate that the mechanism of calculation of the fair market value will be specified by the tax department and thus leaving lot of discretion in the hands of the Tax Officer, which could be a dangerous proposition.
While relaxation of the tax regime for private equity and venture capital funds registered with SEBI is a welcome move and will bring certainty in their taxation, the introduction of General Anti-Avoidance Rule (GAAR) and retrospective amendment to tax offshore transfers will increase uncertainty for foreign private equity funds. The introduction of a retrospective tax on indirect transfers of controlling interest in an Indian company will make the strategic investors who invest in private equity-funded companies to put on their thinking caps and better scrutinize their options. Even the transaction costs are likely to go up, as the private equity funds will now have to factor additional capital gains tax costs while closing investments and planning exits. Thus, overall the budget proposals seem to be more of a dampener, particularly for the foreign players.
Kindly illustrate one or two ticklish issues faced while structuring a PE deal.
In one of the transactions, the foreign investor intended to adopt the FVCI route for making investments in India, to take the benefit of pricing policy. The extant foreign exchange regulations provide that FVCI investment can be made at any mutually agreed pricing (rather than the DCF valuation method prescribed by foreign exchange regulations fornormal foreign direct investments). Though the regulations do not contain any restrictions on the mode of divestment by FVCI, RBI seems to be of the view that at the time of exit, FVCI investors can sell only to domestic entities or another FVCI. Hence, the exit by such investors could be a challenge. In this particular transaction, the nature of investee’s business was also such that finding a non competitive buyer would have been a task. Hence, while structuring the client chose not to adopt this route.
In another transaction, our client was the second round and a true private equity investor while there were certain angel investors already invested in the investee company. These angel investors had pre-emptive anti dilution rights. While they were willing to accept the second round private equity player, they wanted to enjoy the upside as well, without pumping in additional funds. Hence the transaction was structured in a very delicate way to meet the aspirations of the promoters, angel investors and the second round private equity player. One of the foreign private equity players typically followed the philosophy of investing through equity and convertible instruments across jurisdictions. However, it had to change its plans in India, since the foreign exchange regulations consider convertible instruments as debt, rendering them liable for compliance with the regulations governing the external commercial borrowings, which may prove to be too cumbersome.
Some other structures like the partly paid shares, post closing adjustments etc. can also become a challenge, at times.
What are the critical issues in the documentation of PE deals?
Criticality of the issues varies from transaction to transaction and nature of the investee company e.g. enforcement of some of the shareholders rights could be different in case of a public or a private company.
As a thumbrule, the documents need to be water tight to provide for the requisite return on equity and an appropriate exit mechanism for the PE investor. Certain aspects like the milestone linked payments (if applicable), role of the promoters, preemptive rights such as the right of first refusal, tag along, drag along, antidilution etc. also need to be captured aptly. Enforcement of some of such rights could be a challenge at times, particularly in case of public companies. Hence the drafting has to be precise and cognizant of the validity/ enforcement of the rights and obligations provided in the agreement. Many a times, exit mechanism prohibits sale to competitors of the investee company. This could also become a big issue particularly in some of the new technology companies, where either there are no clear competitors in India or the business activity of the investee company is such that no one else except a player in that field could be a probable buyer. Besides the above, the events leading to ‘deadlock’ and modes of resolution thereof need to be very clearly spelt out. It should not be a means for causing an easy exit and a balanced approach has to be followed, taking care of the interests of investor as well as the investee/ promoters.
The first step in a PE deal may involve match making of investor and investee by a professional organization or may involve scouting by the investor or investee for a suitable investor or investee as the case may be this stage may be called deal origination. After the identification of the investor or investee, as the case may be, the term sheet is circulated between the parties to capture the intent and quantum of the deal and to arrive at a commercial understanding. Once the term sheet is finalised then the time to inquire into the veracity of statements as to current strengths, weaknesses and growth potential of an investee and this inquiry in the business legal parlance is known as due diligence conducted by the Auditors and Consultants appointed to conduct the Financial, Tax, Legal and Technical Due Diligence. The due diligence exercise generates a report which forms the basis for detailed negotiations between the parties. The negotiations result in commercial understanding between the parties which is recorded by way of definitive agreements which principally share purchase agreement and shareholders agreement and they also include terms containing clauses pertaining to Investment, Management and Advisory Agreement etc. or in the alternative these agreements may also largely be included in one agreement only. Once the definitive agreements are entered into then is the time to achieve the intended growth objective of the PE deal. That is done by way of closely monitoring the investee company in its operational and financial aspects to realise the expansion plans. As the company starts maturing which usually takes 3 – 5 years with the presence of the experts on the board then is the time to exit either by way of IPO or a Trade Sale or in rare cases a Buy Back by the owners. But it must be kept in mind that every deal has its own peculiarities and thus maynot progress as stated herein but more or less the stages remain the same.
In an article titled “Private equity firms prefer convertibles to direct equity” published in Livemint it was found out that “Around two-thirds of PE deals in recent times have been made through compulsory convertible preference shares”. The basis for that finding as recoded in thearticle was “Convertibles are increasingly becoming the preferred investment instrument for private equity (PE) firms. Around two-thirds of the deals in the PE space in recent times were made through compulsory convertible preference shares, say industry trackers. This is to bridge the gap in the “mismatch in valuation expectations” between investors and promoters.” The simple reason for preference for Preference shares is that they can be tailored to give control to an investor in a private company by contract and through the company’s articles of association. However, preference shareholders will not be able to control a public company or a private company that will be doing an IPO. In the circumstances, deals in India involve a significant equity component.
Companies Act, 1956 and Securities Contracts (Regulation) Act, 1956 (SCRA) govern the issues related with share purchase and share holding in investee companies. FEMA and FDI guidelines collectively constitute the legal regime for foreign investors in India. Master Circular on Foreign Investment in India issued by RBI on July 1, 2011 clearly mentions that Foreign investments in India are governed by sub-section (3) of Section 6 of the Foreign Exchange Management Act, 1999 read with Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time. Securities Exchange Board of India Indigenous and foreign venture capital funds, including PE funds are regulated by SEBI (Venture Capital Funds) Regulations, 1996 and Foreign Venture Capital Funds Regulations, 2000.
Global economic meltdown, need for Prudential norms, and limitation of self regulation: The RBI paper mentioned above outlines the regulatory challenges faced by the regulators the world over qua Private Equity owing to “interconnectedness between banking institutions and private pools of capital such as private equity and hedge funds and their role in igniting and fuelling a systemic crisis.” The paper mentions the factors which led to systemic crisis that the lure of high transaction fees and other revenue earning ancillary services, banks were competing to provide the debt finance for private equity transactions on cheapest and most flexible terms. And because of their ability to distribute debt, banks accepted such high leverage levels without regard to the credit terms, credit quality and interest rates. This has led to a global outcry to regulate financial system so that situations like 2007 global crisis can be averted in future and various bodies came out with their own set of suggestions including G-30 and towards this objective, the European Parliament inOctober 2008 passed a resolution demanding greater regulation of private equity funds calling for capital requirements, binding disclosure and transparency norms, controls on asset stripping and capital depletion and limits on director’s remuneration So prudential norms is the watch word for the financial system suggesting a tighter regulatory regime. And the idea of self regulation has also been as it poses its own moral hazard in the sense that a PE fund may just glorify its successes while brushing its failures under the carpet.
Need for PE specific Legislation: The ambitions of India as noted above requires astronomical sums of capital and private equity is a predominant source of funding for Indian companies seeking expansion, especially when market conditions are not conducive for capital raising from the public through IPOs. But the extant regulatory system creates more ambiguities than infusing clarity and resultantly acts as a dampener. The regulation of Private Equity in India like most countries is at an evolving stage except for US and UK and is regulated within the framework of existing regulations. This system leads to legal ambiguities since PE as an investment option has its own peculiarities and dynamics. So what is needed is PE specific legislation addressing its own issues. Though SEBI has circulated its draft Alternative Investment Fund Regulations wherein a more focused regulation of nine alternative investment funds including Private Equity.
Options controversy and RBI’s insistence on treating them as ECB: The exit options are a life blood for specialized investment funds like Private Equity. But in recent past because of the nature of options like call option, put option etc. RBI insists on treating them as external commercial borrowing as it believed these to be in the nature of debt masqueraded as equity. This has raised the heckles of the Industry. So it will be in the national interest that sooner such controversies are resolved the better it is for the country.
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