Private investment in public equity (or Pipes) were formed two decades ago in the US as vehicles for capital formation, to secure capital from hedge fund investors and high net-worth individual investors, at a time when small-cap companies were facing uncertain financing prospects.
However, in terms of the global markets, Pipes are no more than five years old. In India Pipe deals became popular in 2005, with companies listed on the stock exchange markets were high.
Pipes are investments where a major investor purchases substantial amounts of the stock of public corporations, generally at significant discounts to market prices, are often referred to as 'liquidity discount' requiring a lock-in period before the shares can be sold on the market. Pipe deals are especially popular during periods when financial markets are difficult to tap for public funding, considering that they offer immediate, efficient and cost-effective access to capital than a secondary offering.
Pipe deals are offered by way of private placement or preferential allotment to a limited number of accredited investors, typically private equity firms and venture capitalists.
Parties involved in a Pipe deal (the investor and the company issuing the fresh shares to these investors) must take into consideration several aspects to execute the Pipe transaction.
Development of Pipes in India
Pipes gained momentum in the India between 2005 and 2007. With the Bombay Stock Exchange reaching a record high of 21,206 in 2007 and all investors focusing on the large institutions, a demand for Pipe deals which provided access to public capital markets for mid-cap firms was created.
An analysis of Pipe transactions in 2007 shows that wealth created was highly imbalanced in various sectors. While the overall run on Pipe deals in 2007 was negative, investments made in banking, financial services, telecoms and retail sectors have defined the trend.
Despite stringent barriers such as the lock-in period of one year, Pipe deals in India were popular because the barriers to listing were so low that companies got listed much before they were ready, and ended up with illiquid stock, not actively covered by institutions.
In 2007, private equity firms struck 435 deals to invest $14.3 billion in India. And 30.7% were Pipe transactions. But up to the end of August 2008, private equity firms had invested $8.2 billion through 280 deals, with 18% of this amount being accounted for by Pipes. The deals of 2007 plunged as a result of their high-cost investments and investments in 2008 dropped as a result of the continuous downturn in equities market. Now the global market meltdown following the credit crunch in the US and its subsequent impact on Indian markets has crimped investments by private equity firms.
The sector changes of Pipes are infrastructure (down 87%), retail (down 81%) and pharmaceuticals (down 83%) have fallen the most, while investments in healthcare (down 39%), banking, financial services and insurance (BFSI) (down 48%) and energy (down 43%) are the least impacted.
The global recession and bearish trading sentiments have taken their toll on private equity investments in listed firms. These deals have suffered a loss to the tune of a whopping $1.27 billion so far this year.
Investors are on their guard, and they are paying more attention to the mark-to-market risks associated with putting money in listed companies.
But even though the Pipe market in India may seem bleak, it will not remain so for very long. Once the market begins to turn, India is going to be the most desired destination for global investors.
| Stock market performance |
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| PIPE investments (Figures in $ billion. January to June) |
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Recent deals
With the Sensex at its all-time low, private equity funds are looking for better deals with the listed firms. The downturn in stock valuations has offered private equity firms the opportunity to increase their activities in Pipes. Valuations of listed firms had started going down since the beginning of 2008. During the first eight months of 2008, nearly 20% of the $8.2 billion private equity investments India have been invested in Pipes.
According to analysts this is expected to rise. Most private equity investors have been holding out in anticipation of valuations dipping further as the price has to be based on the six month average for preferential equity and in a few months the average will be reflective of today's prices. This should see a rise in investor interest in Pipes.
What could also boost the private equity investments in the Pipe segment are the recent amendments to the Qualified Institutional Placement (QIP) guidelines. In August 2008, the Securities and Exchange Board of India (Sebi) said that QIPs should be based on the average price of the shares two weeks before the issue. Earlier, the pricing formula was based on the average price of six months or fifteen days, whichever was higher. As a result of the previous pricing mechanism, in a bearish market, the QIP prices always exceeded the current market prices and investors would not be interested in paying a premium for shares, which were available at very low prices.
2007
Pipe deals in 2007 plunged as a result of their high-cost investments (at high market levels). On a conservative basis Pipes constituted 50% of the total investment made by private equity firms in 2007. But the persistent negative sentiments in the stock market have dented the private equity investments. Almost 75% of such Pipe transactions completed in 2007 have resulted in losses, at least in mark-to-market terms or in terms of the present value of their investments. The overall till-date-return on Pipe investments of 2007 was negative 11%.
Ninety five percent of such deals showed negative returns because of the high entry valuations and declining stock market.
2008
An analysis of Pipe investments made in 2008 shows that these deals suffered 54% loss on their initial investment. Almost 93% of the total Pipe deals were into losses. An industry-wise analysis shows worst affected were infrastructure, retail and pharmaceuticals, which were down by more than 80% each.
Also, the investments already made in 2007, saw further erosion in value in the year 2008. Real estate, media, manufacturing, infrastructure and IT were the sectors that were worst hit by the stock market downfall. The loss of value in Pipe deals in each of these sectors was more than 70%.
2009
The global economic crisis has also seen the Indian rupee depreciate which has added to worsening capital market returns. Careful and conscious timely investing will largely drive investment strategies. The private equity funds may not withdraw their investments from their target companies at the cost of losses at current market levels, as they normally have an investment period of four to five years. Private equity is mainly a commitment and not a capital driven investment vehicle. In such turbulent market conditions, none of the investment committees or companies are really in a position to take large investment decisions.
However, capital funds are changing their management strategy because the credit squeeze is likely to last for a long time. As a result, buyouts instead of incubation, mentoring or cashless funding and Pipes are gaining increasing importance. The persistent downturn in the equities market calls for utmost monitoring and careful analysis for fresh investments in the public sector.
Procedures for Pipes in public listed companies
The Indian legal framework has been conducive to Pipe deals. Such investments in India can be made in two kinds of companies – public listed companies and unlisted public companies. Companies make the issuance of securities on a preferential allotment basis.
Pipe Investments in India are subject to certain regulatory requirements:
Section 81 and 81(1A) of the Companies Act, 1956
Section 81 provides existing shareholders with pre-emptive rights to subscribe to shares. Since in a Pipe transaction, shares are being issued to non-members, it is necessary for the company to obtain the approval of its existing shareholders to waive their pre-emptive rights and consent to such further issue. For this, the company must obtain shareholders' approval by way of a special resolution; with a three-quarters majority of the members present and voting. Additionally, obtaining 'in-principle' approval from the stock exchange on which it is listed is required. An explanatory statement attached to the notice calling the general meeting must contain certain disclosures as per Section 173 of the Companies Act, 1956 including the identity of proposed allotees and percentage of post preferential issue capital proposed to be held by them.
Sebi (disclosure and investor protection) Guidelines, 2000
The Sebi Guidelines lay down the pricing norms for the issue. The base price of the share must be calculated by taking the average of the weekly high and low of the closing prices of shares of the company during the six months preceding the relevant date; or the average of the weekly high and low of the closing prices of shares of the company during the two weeks preceding the relevant date. The higher figure is used as the base minimum price for the Pipe.
Before issuing shares, the investee company must obtain a certificate from its statutory auditors, certifying that the issue has been made in compliance with Sebi laws.
As stated in the Sebi Guidelines, the allotment and despatch of the share certificates must be completed within 15 days from the date of passing of the resolution under Section 81(A), failing which, a fresh approval of the shareholders will have to be obtained.
Sebi (Substantial Acquisition of Shares and Takeovers) Regulations, 1997
An investor acquiring shares or voting rights beyond the prescribed thresholds is required to disclose the aggregate of his shareholding or voting rights to the company and to the stock exchanges, where shares of such company are listed.
The company whose shares are allotted by preferential allotment is also required to make these disclosures to all the stock exchanges on which its shares are listed. The prescribed threshold limits are 5% or 10% or 14% or 54% or 74% of shares or voting rights in the company.
Additionally, any acquirer who has bought shares or voting rights of 2% or more of the share capital to the company within two days of such purchase or sale along with the aggregate shareholding after such acquisition or sale. It is the responsibility of such company to disclose to all stock exchanges on which its shares are listed the aggregate number of shares held by each such acquirer within seven days of receipt of information from the concerned acquirers.
Besides this, the Takeover Regulations require an open offer to be made by the acquirer in case the acquisition of shares results in the acquirer holding 15% or more of the capital or voting rights of the company. Such an open offer shall be to acquire minimum 20% of shares from the public shareholders at a predetermined price.
Foreign Exchange Management Regulations (Fema) 2000
The Fema Regulations are applicable when the investor is a resident outside India. Such a person is permitted to make investments in the equity of a company under the Foreign Direct Investment Scheme subject to the specified terms and conditions.
Foreign equity participation up to specified limit percentage of paid up capital in specified activities is under automatic route requiring no approval but only filing the prescribed documents with the RBI. Applications for foreign investment, which do not satisfy the parameters prescribed for automatic route must be made to the Secretariat for Industrial Assistance (SIA) or Foreign Investment Promotion Board (FIPB). In terms of the FDI Policy, if the shares of a company are acquired with a view to buy shares of another company then the automatic route of the investment would not be available. However, in the Press Note 9 of 1999, the Government has allowed downstream investment by foreign owned Indian holding companies in the activities, which qualify for automatic route subject to certain conditions.
Procedure for Pipes in unlisted public companies
The regulatory norms for unlisted public companies are discussed below:
When an unlisted public company wishes to raise capital by way of a preferential issue or private placement of shares as in the case of a Pipe deal, the company must comply with Unlisted Public Companies (Preferential Allotment) Rules, 2003 (the Rules) prescribed by the Department of Company Affairs.
According to the Rules, capital can be raised by way of a Pipe deal by passing a special resolution with a 75% majority vote pursuant to Section 81(1A) of the Companies Act, 1956.
However, the Special Resolution of Section 81(1A) can be passed only if the Articles of Association of the unlisted public companies permits the company to raise the capital by way of preferential allotment or private placement.
Disclosures to be made at the general meeting convened for the resolution will be as per Section 173 of the Companies Act, 1956.
Once the special resolution has been passed, it must be acted upon within twelve months from the date of the resolution. The Rules do not provide specific pricing guidelines, but most companies rely on the latest audited balance sheet of the company. In case of foreign investor the pricing guidelines under the FDI Scheme will have to be followed.
In case of every issue of shares, the statutory auditors of the company or company secretary in practice must certify that the issue of the shares has been made in accordance with these Rules and this certificate must be laid before the meeting of the members convened to pass the resolution.
If an unlisted company were to make an allotment to more than 50 persons at a time under the preferential allotment method, it would be treated as a public issue and it would then have to comply with the relevant provisions of the Sebi Guidelines with reference to initial public offerings.
| Author biographies |
Preeti Mehta
Kanga & Company
Preeti Mehta is a senior partner of Messrs Kanga & Co, a leading firm of advocates and solicitors in Bombay. Mehta qualified as a solicitor both from Bombay and England. She has also undergone an intensive course on franchising at the Middlesex University, London and has several international clients within the area of franchising.
Mehta has been practising for over 25 years and has vast experience in matters relating to foreign collaborations, mergers and acquisitions, private equity investments, corporate laws, banking and franchising – which is fast growing. She has advised various clients including State Bank of India, Navis Capital Partners, Lauris Capital Partners, UB Group Companies, Hexaware Technologies, Shriram Group of Companies in matters relating to corporate laws, capital markets, mergers and takeovers, foreign collaborations, private equity investments, intellectual property and information technology.
Mehta has participated in several international seminars and presented papers as also authored articles on several subjects. Mehta is on the editorial advisory board of the International Journal of Franchising Law and has made contributions to the Journal and other publications. She is a director of Hexaware Technologies, and a member of the Law Committee of the Bombay Chamber of Commerce and Industry.
Chetan Thakkar
Kanga & Company
Chetan Thakkar is a junior partner of Kanga & Co, a leading firm of advocates and solicitors in Bombay. Thakkar has qualified as a solicitor from Bombay. Thakkar has been practising for over 10 years and has experience in matters relating to foreign collaborations, mergers and acquisitions, private equity investments, capital markets, corporate laws, banking, intellectual property rights and franchising.
Thakkar has advised clients on various banking matters, particularly complex banking documentation. He has also handled various matters relating to external commercial borrowings and capital raising, loans, securitisation and factoring. |