Coming of age

Author: | Published: 1 Aug 2007
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India has seen an increased focus on private equity recently and is a country to watch in this area. Reports state that India has attracted the second highest rate of private equity investment in Asia in 2007, ahead of China and behind only Japan.

Cross-border (inbound) private equity transactions constitute the bulk of these deals. Domestic private equity activity is restricted to smaller investments. The investment activity ranges between PIPE (private investment in public enterprises) to acquisitions in unlisted public and private companies, including buyouts, majority rights and minority stakes. Private equity has been flowing into a growing variety of sectors. The traditional favourites are information technology and IT-enabled services but there is increased interest in manufacturing, life sciences/healthcare, financial services and accounting. Some of the biggest deals completed recently have been in the telecommunications and financial services sectors, including Temasek's purchase of 9.9% stake in Tata Teleservices for $300 million and the Carlyle Group's $650 million commitment to the Housing Development Finance Corporation.

As in other emerging markets, the focus of the private equity industry in India is shifting to management teams of the target company. Indian companies are usually managed by strong promoter (families), although a number of professionally run firms are now coming to the fore. In the traditional model, the promoter partners the private equity investor as a shareholder and through joint control of the board. However, a different model – the management buyout (MBO) – recently came under the spotlight when, in the largest management buyout ever in India, the management team of business process outsourcing firm Intelenet bought out the promoters, backed by private equity fund Blackstone. Activity will increase on the MBO front as more management teams convince investors of their entrepreneurial capabilities to generate return on investment.

Contributors to this growth include the consistent GDP growth of India's economy (over 9%), an increasingly strong appetite on the part of Indian entrepreneurs to partner with private equity investors for innovation, funding and strategic advice, and the steady reduction of regulatory barriers to investment. An economy that is growing exponentially, a democratic government, and a strong and familiar legal system are some of the factors that give India an edge over its strongest competitors in the region. But has India has come of age for inbound private equity?

Regulatory considerations

The Reserve Bank of India (RBI) has, under its foreign exchange regime, historically imposed substantial restrictions on foreign investment into India. These restrictions now continue with respect to limited sectors on the prohibited list. Investment in some sectors requires the approval of the regulator but is generally allowed. By and large, however, the sectors have been increasingly liberalized and foreign investment is primarily under the automatic route (that is, without requiring regulatory approval) in most sectors, subject to compliance with the sectoral caps, capitalization norms and minimum pricing guidelines.

Investment routes

The preferred route through which private equity flows into the Indian market is foreign direct investment (FDI) and foreign institutional investment (FII). The option of coming in through the route of foreign venture capital investment (FVCI) is also available and offers some advantages, such as being exempt from pricing regulations and statutory lock-in. However, FVCIs must be registered with the Securities Exchange Board of India (SEBI) and cannot invest more than 25% of their capital in any single company.


Foreign investment through the acquisition of equity shares is typically the preferred mode of investment, as it enables the acquirer to realize the underlying appreciation of value of the target company and also provides controlling rights in the company. It is also possible to invest in equity shares with differential voting rights in unlisted companies (the regime for issuing such shares in a listed company is still in the development stage). A modified instrument often used by private equity investors is convertible preference shares/debentures with the ability to vote on an as-converted basis. However, according to recent notifications by the Ministry of Finance and the RBI, for the purposes of the applicable foreign exchange laws, only foreign investment in the form of compulsorily convertible preference shares will be treated as part of the share capital and be entitled to the regime under the Foreign Direct Investment Policy. Foreign investment in the form of any other type of preference shares/debentures is considered debt and will have to comply with the guidelines and caps applicable to external commercial borrowings, which are subject to norms relating to eligible lenders and eligible borrowers, restrictions on end use and all-in cost ceilings. Warrants are another often-used instrument for investment by private equity investors.

Corporate structure

Acquisition of shares may be by way of a subscription to fresh shares in the target company or acquisition of existing shares from the shareholders of the target company. If the target company is a listed company, the subscription to fresh shares may be by way of a preferential allotment and would be subject to the requirements of Chapter XIII and Chapter XIIIA of the SEBI (Disclosure and Investor Protection) Guidelines (2000), which prescribe the process of issue and pricing norms applicable.

Tender offers

Whether by way of a fresh subscription or an acquisition of secondary shares, if the acquirer acquires more than 15% of the equity share capital of a listed company or acquires control of a listed company (through the acquisition of shares or shareholder arrangements), the acquirer would be required to make a tender offer for 20% of the public shareholding in terms of the SEBI (Substantial Acquisition of Shares and Takeover) Regulations (1997). The definition of control under the SEBI Takeover Regulations is wide and includes the ability (individually or in concert) to appoint a majority of the directors, or to control the management or policy decisions of the company. The SEBI Takeover Regulations also prescribe triggers to tender offers pursuant to further acquisition of shares by the acquirer. If a shareholders agreement is entered into between the private equity investor and the promoter of a listed target company, the two may be seen to be persons acting in concert and their shareholdings will be aggregated for the purposes of the SEBI Takeover Regulations. Further to recent policy changes, hostile acquisitions by foreign investors are possible, although there are no precedents for this yet.

Going private

Going private acquisitions are subject to compliance with the SEBI (Delisting of Securities) Guidelines (2003). Given the fiscal implications of a delisting offer, where the delisting price is determined through a reverse book-building mechanism, if the investor's commercial interest is restricted to a particular business in the portfolio of the target company, a possible option is to consider the feasibility of the particular business/undertaking being divested into a separate private company by way of a demerger/slump sale/asset transfer, with the private company forming the entity for the joint venture/ acquisition.

Due diligence

Global private equity firms usually require extensive due diligence exercises to be conducted on the target companies before making the decision to invest. Under Indian law, there is no restriction/prohibition that governs due diligence of a private company or an unlisted company. The conduct of due diligence of a listed target company would be subject to the restrictions laid out in the SEBI (Prohibition of Insider Trading) Regulations (1992). However, unlike other jurisdictions, there is no obligation on a listed company to provide the same level of information to various potential acquirers.

Investor rights

Voting arrangements

Except in the case of 100% buyouts, private equity investors usually construct their controlling interest in the company through contractual arrangements with the promoter. This is usually built through a shareholders agreement creating a pooling arrangement between the parties to vote in accordance with the terms of governance with respect to composition of the board and its committees, veto rights, anti-dilution rights, and information rights, where, under the contract, the shares they hold will be voted as one single unit. Indian courts have recognized the validity of voting arrangements between shareholders (see Rolta India v Venire Industries (2000)) but they must be incorporated into the articles of association of the target company to be rendered enforceable (see IL & FS Trust v Birla Perucchini (2004)).


With respect to a listed target company, shareholder arrangements are seen to be the acquisition of control and result in an open offer being triggered under Regulation 12 of the SEBI Takeover Regulations. In deciding which rights to include in a shareholders agreement, some PIPEs investors forgo the typical list of corporate transactions requiring affirmative votes of the investors (such as veto rights over new issuances of equity, hiring and firing senior executives, incurrence of debt, and large acquisitions or divestments) to avoid being deemed in control.

Differential voting rights

Although the law provides for the issue of equity shares with differential voting rights to be issued by unlisted companies, the regime for equity shares with differential voting rights in listed companies is still in the development stage. Upon final clearance by the SEBI, with suitable amendments made to the relevant regulations on how to deal with such shares issued by listed companies, this could be an option for a private equity investor seeking a specified voting power as its commercial objective.

The investor's exit

Shareholder agreements routinely contain provisions that detail the manner in which the investor may exit its investment, including by causing the target company to undertake an initial/secondary public offer, sponsored ADRs/GDRs, sales to third party buyers, put-options on the promoters, and buy-back of shares by the company. In the case of listed companies, the transfers may be completed by way of an on-market transaction through a sale on the floor of the exchange, or to an identified buyer through the block trade window (subject to the relevant conditions being satisfied) if the transfer price is roughly the prevailing market price (so as to pay only a securities transaction tax and take the benefit of a lower rate of taxation) or an off-market transfer (which would be subject to a higher rate of taxation).

Transfer restrictions

Arrangements in relation to the transfer of shares or restricting the transferability of shares would have to be incorporated into the articles of association of the company to be enforceable. There is still some doubt as to whether transfer restrictions such as the right of first refusal and rights to tag/drag are enforceable with respect to shares of public companies in light of Section 111A of the Companies Act 1956, which mandates that shares of a public company must be freely transferable. The enforceability of put/call options of shares of a listed company is also not free from doubt owing to a notification from the SEBI in March 2000 stating that, except for certain kinds of spot delivery contracts, contracts for the sale of securities would be void.

Exchange control

Repatriation of the sale proceeds is generally freely permitted, though in certain circumstances, the RBI's approval might be required. Transfer of shares between residents of India and non-residents is regulated by the Foreign Exchange Management Act 1999 and its various regulations, which among other things prescribes restrictions on the price at which transfers may take place. It is important to consider the applicable pricing restrictions and ensure their enforceability when structuring mechanisms for exit.

The Indian private equity market has witnessed some remarkable exit stories, the most remarkable being the $1.6 billion return that Warburg Pincus made on its investment of about $300 million in Bharti Tele-Ventures. This exit perhaps best illustrates the potential of the Indian market and its attitude towards foreign investment.

Areas of concern

Although private equity has been fuelled by a phenomenal growth of the economy, more capital is being invested than can be deployed efficiently and some analysts suspect that the private equity market might be suffering from a problem of "too much". So the private equity focus is subject to larger market forces and the continuing appetite for elevated prices in a market where the Sensex hits an all-time high on a weekly basis.

Private equity regulation

At present, private equity investors are unregulated entities, but they are gradually coming under the scrutiny of regulators. There has been some speculation around whether private equity investors should also be required to be registered with the SEBI or such other suitable regulator (as in the case of FVCIs).


The buyout model has yet to take hold in India. Going private transactions offer much promise, but minority squeeze outs are not possible in India. If the minority shareholders refuse to tender their shares after a delisting/open offer, the investor cannot force the minority shareholders to exit.

LBO hurdles

Another issue limiting private equity investment in public companies is that it is not possible to carry out a leveraged buyout (LBO) on account of the restriction under Section 77 of the Companies Act 1956 that prohibits a company from providing financial assistance for the acquisition of its shares. Also, stringent exchange control restrictions by the RBI on the creation of pledge of shares of the target company in favour of non-residents, limitations on capital market exposures for banks and end-use restrictions for foreign debt impede the sources of funding for investment.

Tax treaties

Double taxation avoidance agreements with Mauritius and some other countries are being reviewed by the government of India and there is speculation that they might be renegotiated to make them more stringent. Alternatives to the typical India-Mauritius route will have to be devised to ensure that excessive and repetitive taxation does not dampen the private equity appetite.

Balancing act

As India moves towards full capital account convertibility, private equity is settling into a comfortable realm. A number of issues need further consideration and the regime is still in the process of development, but growth opportunities provide the suitable counterbalance to bolster the risk appetite for investment. But it is not always a question of more (and rightly so). Activity in real estate, for example, has substantially decreased due to increasing sector-specific regulatory restrictions, and the long gestation period for return on investment in the sector has resulted in a (temporary) reduction in foreign investment. Conversely, India might soon see increased investment activity in retail and banking, due to the phased reduction of restrictions on foreign investment in these areas.