India: Pipe dreams

Author: | Published: 1 Oct 2010
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The market meltdown during the global financial crisis witnessed private investment in public equity (Pipe) deals in India tumble from an aggregate value of $5.9 billion in 2007 to $1.4 billion in 2008 and thereafter, to a mere $640 million across 41 deals in 2009. With the Indian economy reviving to a healthy 8% GDP (expected) for the year 2010, investor sentiment seems to be perking up with 16 Pipes worth $456 million being completed in the first two quarters of 2010.

Indian Pipe deal structures involve several nuances in order to address specific regulations issued by the Securities and Exchange Board of India (Sebi) such as the Sebi (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (Takeover Code) which deals with takeovers of public listed companies in India, the Sebi (Issue of Capital and Disclosure Requirements) Regulations 2009 which deal, inter alia, with preferential allotment of shares, and the Sebi (Prohibition of Insider Trading) Regulations 1992 governing the usage of price-sensitive information that is not publicly available.

Of the aforementioned Sebi regulations, the Takeover Code arguably has the most significant impact on Pipe deal structures as it limits the quantum of investment permissible without triggering a mandatory open offer to acquire an additional 20% stake from the public shareholders of the company and also curtails the customary minority rights that a prospective investor may negotiate with the promoters/company without resulting in the promoters ceding control to the investor and thus obligating the investor to make an open offer to acquire a minimum of 20% from the public shareholders.

The present Takeover Code, in just over 13 years of existence, has been amended 23 times in response to developments in the domestic and international markets and various regulatory and judicial rulings. Recognizing the need for more systemic reform to the present Takeover Code, last September, Sebi constituted the Takeover Regulations Advisory Committee (Trac) with the mandate to examine and review the Takeover Code.

In July this year, Trac submitted its Report on the Takeover Code (Report), including a draft text of recommended regulations, with several substantive changes that could have a significant impact on Pipe transactions. At the time of going to press, the deadline set by Sebi for comments from the public on the Report had just expired. It is expected that many of the fundamental changes recommended by Trac will be accepted by Sebi and a revised set of takeover regulations broadly in conformity with the draft regulations recommended in the Report will be given effect to in the coming few months.

Enhancement of initial trigger

The current threshold of 15% was introduced in an environment where it was possible to exercise substantial voting power and even control a listed company with just a 15% shareholding and that promoter shareholding in most Indian listed companies have since shored up significantly. The Report places the mean and median of promoter shareholdings in listed companies, currently, at 48.9 % and 50.5 % respectively and notes that less than 8.4 % (in number) of listed companies are presently declared to be controlled by promoters holding 15 % or less. In recognition of this fact, Trac has recommended the enhancement of the initial trigger by 10 percentage points to 25%.

This would be a welcome change for both private equity investors seeking more meaningful stakes and companies seeking to raise larger sums of money, without the investor triggering a mandatory open offer.

While this change prima facie means that private equity investors can now acquire up to 24.99% in a company (technically less than the statutory threshold ownership of more than 25% required to block special resolutions) without triggering a mandatory open offer, the practical implication is that given the history of a certain degree of absenteeism by public shareholders at shareholder meetings of Indian companies, private equity investors can effectively acquire more than 25% on a present and voting basis without triggering a mandatory open offer. This will allow for a greater say for private equity investors in the governance of the company and provide some level of comfort to private equity investors who are unable to procure affirmative voting rights to the extent that they are ordinarily accustomed to on account of the risk of Sebi perceiving such rights as amounting to the promoters ceding negative control to the investors and thus triggering a mandatory open offer. This has long been a matter of contention between the investor community and Sebi, and, recently, came to a head in the dispute between Subhkam Ventures (I) Pvt. Ltd. and Sebi (the Subhkam Case). In January this year, the Sebi Appellate Tribunal (Sat), rejecting Sebi's contention that minority protection rights such as affirmative voting rights would be tantamount to control, ruled in favour of the private equity investor. Though the decision has been much lauded by the investor community, Sebi has appealed the decision to the Supreme Court, where the matter awaits adjudication.

Offer size

The Report views the current requirement of a minimum offer size of 20% as inequitable and unfair to public shareholders in as much as it permits a substantial shareholder a complete exit as opposed to the public shareholder who would get to exit only partially if the response to the open offer is larger than the size of the open offer. Accordingly, the Report recommends that an open offer ought to be for the entire extent of the remaining shareholding of the target company. This proposition appears, at some level, to seek to balance concerns of promoters that may stem from the proposed enhanced initial trigger threshold of 25%, by ensuring that any potential acquirer seeking to consolidate their shareholding over 25% would need to make an offer for 100% of the company. Trac also seeks to justify the quantum of increase of the mandatory open offer on the basis of empirical data that indicates that of the 500 offers made over the last 5 years, acquirers have, on average, targeted a post offer shareholding of 67% and accordingly, the enhanced offer size represents only an increase of approximately 50% of what was being targeted previously. This argument may not really work for growth equity funds, but may not be much of an issue for buy-out funds.

This change would make control transactions an expensive affair and may prove a deterrent to many potential acquirers, especially given the limitations on financing of acquisitions in India, viz., the Reserve Bank of India's restrictions on the ability of Indian banks to finance acquisitions and the prohibition under Press Note 9 of 1999 issued by the Department of Industrial Policy and Promotion on leveraging of funds from domestic markets.

While some may argue that the obligation is only to make an offer for 100% and it is not necessary that the entire shareholding would in fact be tendered in the offer, this would still mean that the acquirer will need to go through the rigors of arranging for funding and placing the same in escrow prior to the offer, and to potentially buying a much larger chunk of a company than the acquirer may have planned to.

Defining control

Perhaps weighed down by the appeal against the Sat decision in the Subhkam Case pending before the Supreme Court of India, Trac has refrained from making meaningful changes to the definition of control and has merely recommended that the definition of control be modified to include ability in addition to right to appoint majority of the directors or to control the management or policy decisions. The Report states that the "existence or non-existence of "control" over a listed company would be a question of fact, or at best a mixed question of fact and law" and accordingly, is best answered on a case-by-case basis.

Reportedly, Trac has chosen to avoid a single quantitative trigger concept as is employed in the takeover regulations of the UK, for example, as the shareholding of Indian listed companies are not dispersed as is the case in such jurisdictions.

Admittedly, defining control is an extremely difficult exercise. However, the addition of ability to the definition does not provide additional clarity and only adds to the existing ambiguities surrounding this definition.

By carefully circling around the issues from the Subhkam Case, the Report has missed an opportunity to incorporate many of the investor friendly positions the Sat had upheld with respect to affirmative voting rights, etc. The investor community will now have to wait with bated breath for the outcome of the appeal to the Supreme Court; until then the spectre of an open offer triggered by a change in control by virtue of minority protection rights being granted to a specific shareholder will continue to loom large.

Indirect acquisitions

The Report proposes that where the proportionate net asset value, or the sales turnover, or the market capitalization of an indirectly acquired listed company, represents more than 80% of the net asset value, sales turnover, or the enterprise value for the parent transaction, the proposed regulations would treat such acquisitions as if they were direct acquisitions and thus obligations relating to timing, pricing and other compliance requirements for an open offer would be applicable. For some complex growth equity deals, the proposed rules on reckoning indirect acquisition of shares may spell needless problems, as the said rules equate indirect ownership with direct ownership if the target company is a substantial part of a holding company where a change in ownership occurs. This rule, we expect, may cause concern amongst private equity investors as it could affect the options for structuring investments through holding companies.


A necessary consequence of increasing the offer size to a minimum of 100% would be that an acquirer may end up acquiring shares in excess of the maximum permissible non-public shareholding of the target company (generally 75%) or even the delisting threshold (90%) of the target company.

The Report notes that it would be unfair to require acquirers to necessarily sell down their shareholding to meet the minimum public shareholding requirements if they have crossed the delisting threshold through an open offer and it would be unduly onerous to require such an acquirer to make another offer Sebi (Delisting of Equity Shares) Regulations, 2009 (Delisting Regulations). Accordingly, the report recommends that if the acquirer declares an intention to delist the target company, and the shares tendered in response to the open offer enable such acquirer to cross the delisting threshold, such a company should be allowed to delist under the takeover regulations itself.

This simplifies the process for take-private transactions allowing for seamless delisting pursuant to a successful open offer for more than 90% of the target company's shares. However, as rightly noted by Trac, the takeover regulations do not and cannot provide for a right to squeeze out minority shareholders and separate amendments to other regulations/statutes (including the Delisting Regulations and the Companies Act 1956) will be required to affect the same.

No non-compete fees

In keeping with the philosophy of equitable treatment of all shareholders, the Report proposes to do away with the existing permission for payment of non-compete fees to promoters of 25% in excess of the offer price. Accordingly, the report recommends that the minority shareholders should get the same price for their shares as the promoters or the exiting controlling shareholders, including any amounts classified as non-compete fees.

Arguably, it is not unfair for an exiting controlling shareholder to demand a premium in exchange for a controlling stake in the target company. However, as witnessed by the recent controversy surrounding the payment of non-compete fees by Vedanta to Cairn India, even under the current Takeover Code, Sebi is querying the veracity of payment of such non-compete fees to just one class of shareholders.

Such a prohibition will on the one hand dampen M&A activity and on the other hand induce further creative structuring of such transactions.

The changes suggested by the Report have been met with mixed feelings by industry. However, it is hard to deny or argue with the philosophical grounding of the proposed changes. While we wait for the Sebi to consider and implement the Report, all eyes will now turn to the other regulatory players (such as the RBI and the Ministries of Finance and Commerce & Industry with respect to acquisition finance and the Ministry of Company Affairs with respect squeeze outs) to gauge their response in supporting the proposed changes and facilitating a healthy and robust environment for Indian M&A.

About the author

Vijay Sambamurthi, the founding partner of Lexygen, has valuable
experience from more than a decade representing some of the world's most
reputed private equity funds and multi-national corporations in connection
with their complex legal requirements.

Contact information

Vijay Sambamurthi

Ground Floor, Thapar Niketan,
Brunton Road,
Bangalore 560025

Tel: +91 80  6684 0100
Fax:+91 80  6684 0101

About the author

Roshan Thomas, partner at Lexygen, has significant legal transactional experience representing leading global venture capital and private equity funds in connection with their Indian investments and exits.

Contact information

Roshan Thomas

Ground Floor, Thapar Niketan,
Brunton Road,
Bangalore 560025

Tel: +91 80  6684 0100
Fax: +91 80  6684 0101

About Lexygen

Lexygen is a pan-Indian law firm, with offices in Bangalore and Singapore, focused on providing premium legal representation to a global clientele in the areas of private equity and venture capital, mergers and acquisitions, joint ventures, FDI advisory, infrastructure privatization, and general corporate services. Lexygen enjoys a strong reputation in the market for PIPE mandates, regularly leading complex and first-of-kind transactions.

Ground Floor, Thapar Niketan, Brunton Road, Bangalore - 560025
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