India: Private Equity

There has been a massive inflow of investments from financial sponsors in India in 2021, despite the on-going pandemic and a specially devastating second wave during the second quarter of the calendar year due to the delta variant. Until the end of November 2021, 41 companies had turned unicorns (i.e. companies with the valuation of more than One Billion United States Dollars). Indian Companies have raised a record of approximately USD 60 Billion, across 950 deals from financial sponsors in the first ten months of 2021. The aforementioned figures surpass the total amount of investment of approximately USD 39.5 Billion that the country received in 2020.

A trade seller is expected to be in day-to-day control and operations of a company. There is accordingly a heightened accountability that trade sellers are subjected to. They are usually required to provide comfort through detailed representations, warranties and corresponding indemnities, in relation to the business of the company. Trade sellers, more often than not, also have more than just monetary interest in any claims that may arise. Financial sponsors, on the other hand, are expected to return capital to their LPs and have limited fund life and therefore the deal terms are negotiated keeping these limitations in mind. By the time of an exit, funds are typically nearing the end of their cycle. These limitations structurally confine financial sponsors from exposing themselves to risks other than those that are fundamental to their ability to transact, namely, title to shares, tax status, authority and capacity related indemnities and warranties. To this end, the degree of diligence (whether seller led or buyer led), is far more when dealing with a selling financial sponsor. Unless any business warranty is for some key aspect of the business; limited in duration; and monetarily capped to a small percentage of the overall deal value, it is not common for a financial sponsor to back any warranty relating to operations of the business. W&I insurance is also common in transactions where the target is primarily held by financial sponsors.

Separately, most purchase agreements for purchase of securities from trade sellers will have covenants to ensure a smooth transition and handover for a specific period of time following completion. Restrictive covenants on trade sellers (such as non-compete) following completion are also widely seen.

Depending on the mode in which the shares are held i.e. physical or electronic, there are two processes for transfer of shares in India. Shares, in physical form are transferred through execution of a share transfer deed in the form SH-4, as prescribed under the (Indian) Companies Act. In case of shares in electronic form, the seller is required to provide delivery instruction slips to the depository holding the shares. Upon receipt of the delivery instruction slips, the depository effects the transfer from the electronic share account of the seller to that of the purchaser. The set-up of the electronic share account in India can be time consuming for non-resident purchasers and, accordingly, this should be processed early on in order to avoid this becoming a gating item.

In addition to the stamp duty payable on the share purchase agreement (which is state specific) if executed or enforced in India, stamp duty is payable at the rate of: (i) 0.015% of the consideration for transfers on a delivery basis i.e. without involving a clearing house and the shares are credited to the buyer’s account, on same day as being sold by the seller; or (ii) at the rate of 0.003% of the consideration for transfers on a non-delivery basis i.e. involves a clearing house and shares take certain days to credit to the buyer’s account. Further, where either one of the seller or the purchaser is a person resident outside India, the Indian resident is required under Indian foreign exchange laws to file the Form FC-TRS with the Reserved Bank of India in the prescribed format within sixty days of transfer of equity instruments or receipt / remittance of funds whichever is earlier.

In private companies, upon transfer of shares through either the form SH-4 or through a depository, the board of directors of the company is required to take on record such transfers and further record such sellers in their register of members as a shareholder (if the shares are in physical form). Some companies insist on Form FC-TRS having been filed in order to taken on record the transfer of shares. While public companies are mandated to issue and hold their shares in dematerialized forms, private companies in India are also transitioning towards dematerialization of their shares, given the cumbersome processes involved maintenance and transfer in physical shares.

Under Indian tax law, while residents are subject to tax on their global income, non-residents are subject to tax on income which is ‘sourced’ from India. In this context, in case of non-residents, gains arising on transfer of: (a) shares of an Indian company; and (b) shares / interest in a foreign entity which derive ‘substantial value’ (essentially 50% or more, to be computed as per the prescribed rules) from assets situated in India, are considered to be income sourced from India and hence, chargeable to tax in India. The taxation under domestic law is subject to beneficial provisions, if any, under the tax treaty between India and the jurisdiction of tax residence of the non-resident. Treaty eligibility depends on several factors including substance related requirements in light of the general anti-abuse rules under domestic law and changes brought about by OECD’s multi-lateral instrument (MLI) to the tax treaties covered by the MLI.

Tax is payable on the gains arising to the seller; to be computed as the difference between the sale consideration and the cost at which the shares were acquired by the seller. Any expenses incurred by the seller on the transfer are generally available as a deduction for computing taxable gains. The rate of tax ranges from 10% to 40% (plus applicable surcharge and cess), depending on factors such as the period of holding and legal status of the transferor. There are certain valuation requirements and in case of sale at a discount to the fair value of shares (determined as per the prescribed rules), there could be tax implications in the hands of the seller as well as the buyer on a deeming basis. In terms of procedural and compliance requirements, where the transaction is taxable in the hands of the non-resident seller, the buyer would have a corresponding obligation to withhold the applicable tax at source and would be required to undertake remittance and withholding tax related filings. The seller would be required to file a tax return in India reporting the income earned from India. For India tax filings, both the buyer as well as the seller would be required to obtain tax registrations in India.

Sellers typically need certainty that a buyer will have access to immediately available funds to prevent a delayed or a failed completion. In India, some sellers may not insist on this when negotiating with a marquee financial sponsor, however, this question is front and center of most negotiations these days owing to the deal uncertainty one witnessed in the early part of the pandemic. Comfort on this issue is typically provided by way of an equity commitment letter. Separately, where a portion of the consideration is debt financed, a debt commitment letter from the lenders may also be provided setting out the conditions to making the debt available. This may also be coupled with a fund guarantee requiring the financial sponsor to fund the total amount in case debt is not disbursed and they are also expected to warrant availability of funds and ability to draw down debt if conditions under the acquisition agreements are satisfied.

Further, in the event the SPV is formed with the backing of multiple co-investors, we have also seen one-off instances where companies have insisted that a particular financial sponsor undertake that its stake in the SPV will not be diluted below a certain threshold and that the management of the SPV will remain in its hand.

Locked box pricing mechanism is fairly common for all primary transactions in India and minority secondary transactions as well. Valuations in these instances is on the basis of financial statements as of a particular date. There are detailed warranties as to changes since the accounts dates and a detailed code of conduct between signing and closing, which restrict the ability of the seller or the company to incur any expenses unless the same is approved by the purchaser or is otherwise permitted as a leakage on account of ordinary course of business. Buyout transactions may often require purchase price to be adjusted basis true-up of the actual cash, debt and working capital as on completion. In buyout transactions that involve a resident seller, one also sees a hybrid approach where there are sufficient restrictive covenants until completion, coupled with a purchase price adjustment.

The extent of allocation of risk is determined by several factors, including the stake of investment of a financial sponsor, promoters’ interest and level of involvement in the company, proposed life of the investment and whether there are other financial sponsors on the share capital table to provide commercial comfort.

To the extent the risks are imminent and quantifiable, purchase price adjustment is the recommended route for a buyer. Buyers also at times will withhold purchase price to ensure smooth transition of the business from the sellers, cover any matter that will be addressed by the sellers over a period of time, and cover any potential claim that the buyer discovers on assuming control. Where purchase price adjustment or holdback is commercially not an option as most sellers will push back on these asks, buyers will typically require the sellers to rectify high risk items prior to completion of the transaction and lesser items (more clean-up) are left to be undertaken within a defined period of time, following completion. In the event any identified risks cannot be addressed prior to completion or which are not immediately quantifiable, such risk items are covered as specific indemnity matters or post completion covenants that the seller is expected to complete or abide by. Buyers will expect specific indemnity matters to not be limited by time or monetary caps whereas sellers will look to limit them at least to time (if not monetary caps).

Representations, warranties coupled with indemnities are sought from sellers to mitigate any other risks. The extent of the warranties and the manner of disclosure against the same can again be a contentious matter where each party will try to limit their own risk to the maximum extent. Sellers will look to push the buyer to acknowledge its satisfaction of the diligence and expect the buyer to confirm that other than matters which are addressed in the acquisition agreement, there are no other matters that can give rise to a claim following completion. Buyers, on the other hand, will look to limit disclosure to specific items to be disclosed, fully and fairly, against specific warranties and resist any non-specific disclosures or reliance on the buyer’s knowledge from the diligence exercise.

The limitation of liability in respect of claims relating to any breach of warranties are also subject matter of debate between the parties. It is fairly common for there to be, inter alia, time caps, monetary caps and thresholds (de-minimis and basket) to bring a claim.

Material adverse effect or material adverse clause is equally a sensitive subject between buyers and sellers. Sellers will look to have a watertight clause to limit any ability of purchaser to walk out of transaction, whereas buyers will look to expand the clause for any unforeseen event which has not been taken into account, at the time of signing of the transaction. Termination rights will also see a similar debate where a buyer will expect a walk away right on account of any breach, whereas the seller will want to ensure that the transaction is completed after it is signed.

W&I insurance is commonly evaluated in buy-out deals especially where targets are majority held by financial sponsors as financial sponsors need to limit any financial exposure to the maximum extent possible following their exit. In the year 2021, more deals relied on W&I insurance when compared to those in 2020. This may be attributed to large number of buy-out / control transactions in India. However, the cost of the insurance can be a cause of concern for some buyers and sellers. Further, W&I insurance is often not available in regulated sectors and, if available, is subject to lengthy list of exclusions, that make it unviable.

Indian stock exchanges have seen a larger amount of activity, in terms of listing during 2021, which has led to an increase in large public market trades. This is expected to rise with the listings of start-ups, which turned unicorn, towards end of 2021 and early 2022. Financials sponsors are fairly active in purchasing minority stakes in listed companies. These investments are largely on the financial performance of the stock in the market with no rights as such. While buyout / take private transactions are traditionally not very prevalent in India, financial sponsors are increasingly exploring opportunities in publicly listed companies, including through buy-out and take private deals.

According to Indian Brand Equity Foundation in its analysis for the ‘Infrastructure’ sector for September 2021, in the financial year 2020-21, infrastructure activities accounted for 13% of the total foreign direct investment inflows, for an approximate USD 81.72 Billion. As per publicly available information, we note that 5 transactions, were undertaken until the end of October, 2021, involving publicly listed infrastructural companies.

With the government actively pursuing liberalisation, sectors that require specific government approval under foreign exchange regulations prior to investment are narrowing down. The year 2021 has been no exception in this regard with the government liberalising the insurance and the telecom sectors by doing away approval requirement for acquisition of shareholding up to 74% by non-residents. There still remains a complete prohibition on foreign investment in lotteries, gambling including casinos, chit funds, real estate business, manufacturing of cigars, cigarettes and other tobacco products. Further, there is a complete ban on foreign investment in atomic energy and the railways. Certain other sectors that require approval under foreign exchange regulations include: (i) defence (beyond 74%); (ii) banking (beyond 49% and up to 74%); (iii) print media and digital media dealing in news and current affairs (up to 26%); (v) multi-brand retail trading (up to 51%); and (vi) pharmaceuticals (beyond 74% in case of brownfield investments).

If the investing entities have a beneficial owner from a country sharing land borders with India (including Hongkong, Macau and Taiwan), such entities, pursuant to the introduction of Press Note 3 of 2020 (PN3), require an approval prior to completing any Indian acquisition. PN3 does not provide any definition or threshold for determining such beneficial ownership. Indian companies and sellers are increasingly looking to seek protection from any PN3 risks from the buyer. Accordingly, if financial sponsors have limited partners from any of these jurisdictions (such as China, Honk Kong, etc) they may need to evaluate this issue closely to determine compliance with PN3.

In February 2021, the Reserve Bank of India (RBI) has restricted investors from FATF non-compliant jurisdictions from acquiring “significant influence” in or more than 20% of the voting power in non-banking financial companies in India (NBFC), including potential voting power. While the RBI circular exempts investors that made investments from such jurisdictions prior to such jurisdiction (including any intermediate jurisdiction) having been notified as FATF non-compliant, this circular has had some impact on investments in the fin-tech sector. Investments through or from FATF non-compliant jurisdictions now need to be structured to prevent breach of this circular.

Separately, foreign exchange regulations require that, where the Indian resident is a seller, the sale of shares take place at or above fair market value. Similarly, where the Indian resident is a buyer, purchase consideration cannot be more than that fair market value of the securities. There are also restrictions on purchase price hold back beyond certain prescribed thresholds (in value as well as time duration).

Under the Indian competition law regime, any direct or indirect acquisition of assets, control, shares or voting rights of an enterprise, or a merger or amalgamation of enterprises (referred to as ‘Combination’, under the Indian law), which exceeds the financial thresholds prescribed is required to be notified to the Indian competition authority (i.e., the CCI). The notification has to be made prior to the closing of the proposed transaction.

The exemption from notifying, is provided to acquisitions where: (i) the value of the consolidated assets of the target is less than INR 3.5 Billion in India; or (ii) the value of the consolidated turnover of the target is less than INR 10 Billion in India.

In addition to the aforementioned, the CCI has notified certain other acquisitions, which do not ordinarily need to be notified given they do not have an appreciable adverse impact on competition in India. Such exemptions include:

i. an acquisition of less than 25% of the shares or voting rights of an enterprise made solely as an investment or in the ordinary course of business, not leading to a change in control. An acquisition of less than 10% of the total shares or voting rights of an enterprise is deemed to be ‘solely as an investment’ provides that it does not confer:

• any special rights (other than those exercised by an ordinary shareholder);
• a board seat (or the right or intention to appoint a board seat); or
• a right that would suggest an intention to participate in the affairs and management of the target.

ii. an acquisition of any additional shares or voting rights where the investor or its affiliates already holds 25% or more (but less than 50%) of the shares or voting rights, as long as such acquisition does not result in such investor holding 50% or more of the shares or voting rights and does not result in the acquisition of sole or joint control of the target.

To facilitate approval of Combinations, the CCI has also established the concept of ‘green channel’ filing, wherein Combinations are deemed to be approved upon notification. The parties to a proposed transaction are required to self-assess and as long as such a transaction would not result in horizontal, vertical or complimentary overlaps in any of the alternative relevant markets – they are considered fit for the green channel approval. The parties are required to submit an undertaking to this extent while notifying the transaction. In case of acquisitions by financial sponsors, the sponsors’ portfolio investments are assessed to determine if any of them could be horizontally, vertically or complementarily linked to the target investment.

Typically, where an approval is needed, the financial sponsor, being the acquirer, has the obligation to file an application for approval and the same is obtained as a condition precedent.

Minority investments are common by financial sponsors. They are primarily structured as equity investments with minority protection. The preferred mode of investments is through a mix of nominal equity and mandatorily convertible preference shares. While acquiring minority stake in companies, financial sponsors also negotiate for protections in the nature of anti-dilution, seniority in liquidation preference upon occurrence of pre-determined liquidity events, event of defaults, put option on the promoter in case exit is not provided or upon occurrence of an event of default, and in limited circumstances even an ability to drag or cause a liquidity event by running a process.

Debt like investment is not common in India due to the legal limitations that require convertible instruments including debt to convert at minimum pricing guidelines. It is possible to structure debt like investment in certain cases if the buyer is willing to seek certain registrations which permit debt like instruments to be purchased. These require a detailed tax analysis to confirm that there is no adverse impact of the structure on the buyer and the seller.

In India, management incentive schemes are typically structured as employee stock option plans (ESOPs). Shares acquired pursuant to the same are typically able to seek liquidity upon subsequent fund raises, listing on stock exchange or at the time of the exit of the financial sponsor – depending on the terms of the issue. ESOPs have provided beneficial returns to management across wide cross section of companies that have exited through listing or secondary buyout transactions.

While ESOPs are popular, they cannot be issued to promoters of companies or directors holding more than 10% equity shares in the share capital of the company, directly or indirectly, unless a company is registered as a start-up with the Ministry of Commerce and Industry Government of India. Due to this limitation, promoters of companies use alternate mechanisms, such as issuance of convertible preferred instruments that provide an equity upside in future if performance milestones are met.

Under Indian tax law, employment linked incentives (whether in cash or in kind) are taxable as salary income in the hands of the employees and the employer has an obligation to withhold applicable payroll tax. In case of certain in-kind perquisites, there are prescribed valuation rules to determine the taxable value of such perquisites.

In relation to equity linked incentives provided to employees / management, the tax provisions specifically recognize and deal with the taxability of stock options. Tax is payable at the time of “exercise” of the stock options by the employees and is based on the fair value of the underlying stock at the time of the exercise. The difference between the exercise price (if any) and the fair market value (computed by a prescribed valuer) is taxable in the hands of the employee as an employment linked incentive / salary / perquisite; and the employer has a payroll withholding tax obligation on the same. At the time of future transfer of such stock by the employee, the fair value based on which tax has already been paid by the employee shall serve as the cost-basis of the stock, and therefore, tax shall only be payable by the employee on any gains in excess of such fair value (as at the time of exercise).

The Indian tax law does not expressly deal with other forms of equity incentives and taxability is determined as per general principles ie: (i) the tax event arises when the benefit accrues or arises to the employee; and (ii) the fair value of the benefits / incentive is considered as taxable perquisite in the hands of the employee and employer has a corresponding payroll withholding tax obligation. Therefore, in relation to the structure of management incentive schemes, one of the key considerations is the timing of exercise / benefits accruing to the management / employees and consequent tax trigger; and where the same is deferred to an actual liquidity event or a buy-out, the taxability as salary should also be deferred – this ensures that the tax cost is funded and the employee does not have to go out-of-pocket to fund taxes arising upon exercise or accrual of benefits in kind where actual sale of stock is not expected immediately.

It is fairly common for senior managers to be subject to non-compete provisions. The typical non-compete period can range from 6 to 24 months, after the termination of employment. Under the Indian contracts law, there are limitations with respect to the kinds of agreements that can be entered into in ‘restraint of trade or business’. Non-compete restrictions, subsequent to termination of employment, may be construed to be in restraint of trade or business. Nonetheless employment agreements generally contain a non-compete restriction to set out the expected behavior. Companies in order to ensure compliance also link certain employee benefit payments, that are paid upon successful completion of the non-compete term, in addition to concepts of gardening leave.

The rights of a financial sponsor are typically set out in a shareholders’ agreement or a composite investment agreement and these are also mirrored in the charter documents of the portfolio company. Most financial sponsors will have board and observer seats along with quorum rights for board as well as shareholder meetings. Financial sponsors also negotiate consent rights and, as such, any key matters (such as business plan, expansion, etc) cannot be approved by the portfolio company until the affirmative vote of the financial sponsor has been obtained in respect thereof. Financial sponsors also often retain the right to nominate the chief financial officer of the portfolio company thereby giving them insight into the spends of the portfolio company and its overall financial health. Wide information and inspection rights also permit financial sponsors to receive key information and inspect the same. It is common to have events of default under the shareholders’ agreement / investment agreement, which have serious consequences and, in most cases, will trigger an accelerated exit or a put option and in some cases, even reconstitution of board.

A management pooling vehicle is not common in India. Certain companies at times do hold the shares in trust for the benefit of employees by setting up an employee welfare trust with promoters or independent / professional trustees.

Senior secured lending is the most commonly used debt finance capital structure. While most small capital financings are in the form of working capital debt, larger financings rely on a range of debt structures, including working capital debt, domestic loans and bonds and international finance. The choice of debt largely depends on the size of the borrower, the type of investor/lender, the purpose of the debt and deal complexity. A summary of some of the commonly used debt finance structures in India are:

1. Working capital facilities: Working capital debt from Indian banks in the form of cash credit, letters of credit, bill discounting facilities, export credit and bank guarantees are most commonly used. Working capital lenders ordinarily have the first ranking charge over the current assets and receivables of the borrower and a second or subordinate charge over immovable assets.
2. Term loans: Most large capital financings are in the form of senior secured term loans from Indian banks and NBFCs through consortium lending, multiple banking arrangements or bilateral facilities. While Indian banks are preferred for large project lending, there are a number of restrictions imposed by the RBI on banks for lending for the purposes of acquisition of immovable property, funding promoter contribution or capital market exposures. International investors can provide loans to Indian borrowers through a specialized route called the external commercial borrowing route (which can be denominated in Rupees or any foreign currency), but it is not the preferred route for many international investors, particularly private equity funds, as it imposes a number of restrictions on use of proceeds (including acquisition finance), term of the debt and a cap on the returns. Common forms of security for term loans include mortgage over immovable assets, hypothecation on movable and current assets, personal and corporate guarantees and share pledges.
3. Debt securities and quasi-equity instruments: Another common form of debt finance capital is debentures and bonds, which can be issued through both public offers and private placement. A number of investors such as banks, NBFCs, alternative investment funds (AIFs), insurance companies, pension funds, mutual funds and private equity funds registered as foreign portfolio investors (FPI) can invest in listed and unlisted debentures, although, FPIs can only invest in unlisted debentures if the use of proceeds is not for investment in real estate business, capital market or purchase of land. Issuance of debt securities to alternative credit providers is preferred as it allows more flexibility in structure and can generally be used for acquisition financing or real estate funding deals. Other instruments like commercial papers, optionally convertible debentures, compulsorily convertible debentures, market linked debentures and various kinds of bonds are also regularly used. More recently, several renewable power companies are looking to issue green bonds.

Indian law prohibits public companies (whether listed or not) from providing any financial assistance (including through loans, security or guarantees) for the purpose of acquisition of its own shares or shares of its holding company. The restrictions on providing financial assistance do not apply in certain cases, for instance, where financial assistance is provided by private limited companies. On account of this exemption, where the group structures permit, private companies are used to implement such transactions.

Most domestic and foreign lenders have a standard form of credit agreements which are broadly based on LMA / APLMA drafts, particularly for large capital financings. There are certain exceptions, such as Indian banks, which usually follow their internal standardised formats.

In case bonds or debentures, Indian company law requires the offer document and trust deed to be prepared in a prescribed format. In addition, the Indian securities market regulator, the Securities and Exchanges Board of India mandates companies which issue listed debt securities to additionally adhere to the formats and disclosures prescribed by it.

While documentation for small capital financings (particularly working capital loans) is usually not negotiated at length, medium and large capital financings are negotiated, and the level of negotiation depends on a number of factors, including the sector in which the borrower operates, diligence findings and size of the transaction. Some common areas of negotiation include financial covenants and leverage thresholds, carve outs and cure periods for defaults, scope of restrictive covenants and materiality qualifiers. The level of negotiations in issuance of debt instruments is comparatively higher than those involved in traditional bank loans.

The legislative and judicial developments under the Indian insolvency regime in the last two years has prompted both lenders and borrowers to re-visit debt documentation. For instance, with the ability of lenders to initiate insolvency proceedings against guarantors, the market has witnessed reluctance from promoters to provide personal guarantees without any monetary caps or without lenders first having recourse to other assets of the borrower. On the other hand, to preserve their position as financial creditors in the insolvency of third party security providers, lenders now insist on guarantees from all third party security providers.

The liquidity crunch and business uncertainty caused by the COVID-19 pandemic led to borrowers seeking waivers from payment and covenant defaults, restructuring of numerous loan accounts and renegotiation of provisions in contracts which were earlier viewed as standard (such as the definition of material adverse change). For new indebtedness, borrowers have increasingly sought flexibility in incurrence of additional debt, financial covenants, cure periods for defaults and the ability to liquidate non-core assets without triggering consent requirements. On the other hand, key negotiation points from the lenders’ perspective have been on protection of yield and ease of enforceability of security, including access to more diverse and liquid security such as share pledges. There has also been a strong push for compliance with Environment Social and Governance standards by lenders.

Yes. In recent times, the Indian market has witnessed high levels of interest in private credit, and particularly distressed credit from private equity funds. The lack of traditional capital on account of mounting bad debt and creditor friendly developments on the regulatory and judicial front have provided the necessary fillip to private credit transactions.

In addition to direct investment through offshore vehicles registered as FPIs, a number of private equity funds have deployed private credit through their local credit arms set up as NBFCs, AIFs, asset reconstruction companies and other vehicles. In many cases, such private equity funds have partnered with local players with sectoral expertise.