Indian M&A in a changed world
Lawyers from Lakshmikumaran & Sridharan explain how the pandemic has impacted M&A deals in India and what potential buyers need to know
The disruptions caused globally by the Covid-19 pandemic and the accompanying lockdowns have led to questions about the extent and duration of the economic downturn, and when the subsequent recovery will come. While the pandemic has impacted all sectors and industries, the pandemic’s disproportionate impact on certain sectors has accelerated the adoption of alternative business models.
This rapid change in position has led to a significant shift in the outlook of investors and large conglomerates, who adopted a wait and see approach for fresh investments after the onset of the pandemic. The effect is visible in the Indian transactional landscape as well.
The way M&A deals are structured has also varied significantly to cope with the challenges posed by the present circumstances and the related uncertainties.
While the Indian government has introduced a slew of measures to give fillip to the economic activity and invite foreign investment, some of its regulatory actions have slowed M&A transactions.
This piece seeks to highlight trends in the M&A space (including the impact on M&A transactions and deal structuring) while also tracking the related key regulatory actions affecting dealmaking in India. Finally, it sets forth opportunities and expectations for M&A in the immediate future.
Sectoral and M&A trends in India
According to the Centre for Monitoring Indian Economy (CMIE), 135 new investment proposals were announced in the first quarter of 2020 (aggregate investment value of INR 561 billion ($7.6 million)), with government projects accounting for 42% of these proposals and the private sector making up the remaining 58%. This is the lowest volume for 16 years.
M&A in India is also not left untouched by the pandemic. As of August 2020, India recorded 776 M&A deals worth $44.8 billion. This is an overall decrease of 14% from last year’s corresponding period. According to Refinitiv’s Investment Banking Scorecard, while strategic M&A - comprising of 626 deals worth $36.4 billion - remained largely constant when compared to the corresponding period of last year, private equity-backed M&A - making up 141 deals of $8 billion in value - saw a 50% slump compared to last year.
As the pandemic introduces us to a new normal of social distancing and travel restrictions, sectors such as civil aviation, hospitality and travel and tourism, which are largely dependent on physical movement of people, have been disproportionately impacted.
On the other hand, this new normal also brings with it new opportunities. With half a billion users –already, the Indian telecoms and digital space is also being seen as an attractive investment arena for global tech giants.
The usual warranties package in a negotiated M&A deal will typically cover the majority of the issues arising from Covid-19
Facebook and Google’s investments in RIL’s Jio Platforms, worth $5.7 billion and $4.5 billion respectively, are testament to this. Companies that have embraced technology and data analytics to come up with new-age models, in traditional sectors such as healthcare and education, are raking in business and investment. For instance, Think and Learn - which operates education technology platform Byju - acquired Mumbai-based Whitehat Jr in a $300 million all-cash transaction, which was one of the most significant deals of this season, and demonstrates the upward trajectory that the ed-tech sector is currently on.
From a healthcare perspective as well, teleconsultations have started gaining popularity rapidly, while on a non-tech front, various hospitals have also sprung up to support needs created by the pandemic. Similarly, Amazon’s launch of online pharmacy and Reliance’s acquisition of majority stake in Netmeds both showcase the potential that the online pharmacy sector has to offer in India.
Other sectors in the technology space likely to see a boost include online gaming (including virtual reality (VR) gaming) and entertainment. Online streaming for visual entertainment are becoming the go-to for most entertainment consumers.
With an emphasis on digitisation and financial inclusion, Indian fintech has also seen positive growth in the first half of 2020. According to a report by Maple Capital Advisors, the sector received investments to the tune of $1.47 billion in the period: 60% growth compared to the first half of 2019. While increased use of digital payments in the pandemic-hit economy will help the fintech sector to flourish, it is reported that at least 60% of the funding received since 2019 has been Series G funding. Mainstream fintech, such as lending and payments, wealth management and insurtech, are already seeing a larger number of players.
The new dealmaking normal
While Covid-19 has disrupted practically all businesses and sectors, including M&A activity, corporates have been required to make difficult choices between calling it quits or facing uncharted territories by pressing ahead with ongoing deals. Decisions have been made largely on the basis of liquidity issues, valuation concerns, regulatory changes, and other practical aspects relating to lockdowns and border closures. In this section, we attempt to highlight some of the well defined concepts in M&A deals that have been or will need to be revisited, especially since the M&A market has now become more buyer-friendly.
Over the past decade, the locked box approach has become popular in India because of the greater deal certainty it offers. However, the market uncertainty caused by Covid-19 has created a lot of difficulties in valuing businesses, which of course helps parties to arrive at the purchase price. As a consequence, most buyers will look to shift to the purchase price being determined by the post-closing price adjustment mechanisms.
Post-closing price adjustments are increases or reductions to the purchase price to account for changes in the target’s financial condition between signing and closing. In order to give effect to the post-closing price adjustment mechanism, the parties can consider either or a combination of any of the following:
post-closing performance-related contingent price mechanisms such as an earnout that is contingent on the achievement of certain financial metrics, milestone events or targets during a specified period after closing;
deferred payment of a portion of purchase price linked to a future contingency;
retention/holdback of a portion of the purchase price to secure potential indemnity claims against the seller or any uncertainty arising from the pandemic; and/or
post-closing adjustment by reconciling differences between the company’s latest balance sheet figures and the figures existing as on the closing date of the transaction. With net working capital adjustment being the most common purchase price mechanism, the parties may look to negotiate caps on the adjustments to protect their interests.
The provisions of the extant foreign direct investment (FDI) policy in India also enable the parties to structure their transactions to factor in price adjustments, providing a time of up to 18 months for deferring payments with a ceiling of 25% of the transaction value for the quantum of deferred payments.
As an enabling measure, the policy also permits the deferred payment to be parked in an escrow account for the specified time period. These relaxations, however, are subject to the pricing guidelines prescribed under the FDI policy which may pose problems for transactions which, owing to the present circumstances, may necessitate heavy price adjustments. Therefore, any move by the government to provide additional relaxations for the parties to structure their price adjustment mechanisms would be a welcome step and is likely to enhance the interest of foreign buyers looking to make acquisitions in India.
While closing adjustment mechanisms may work better in these trying times, this may be temporary in nature and the parties may go back to the locked box mechanism in the long run as the effects of the pandemic wear down and market volatility gives way to stability.
Material adverse change
Historically, material adverse effect or material adverse change (MAC) clauses in M&A deals were heavily negotiated, given that they provided the purchaser with a walk-away right. Purchasers will insist on the inclusion of specific conditions linked to Covid-19 (for example, a second wave of the virus, a significant interruption of supply chains, or a decline in sales). Sellers will be keen to expressly exclude the effects of Covid-19 and include concrete materiality thresholds to ensure that the acquisition agreement does not include any vague or unspecific conditions related to Covid-19 that are subject to the purchaser’s discretion and allow the buyer not to close a deal.
This will lead to longer negotiations, and will require innovative drafting by deal lawyers to ensure limited ambiguity in the MAC clause.
Warranties and W&I insurance
The usual warranties package in a negotiated M&A deal will typically cover the majority of potential issues arising from Covid-19. However, buyers would benefit from understanding the detailed aspects of the business of the target concerning the risks emanating from the pandemic and building in appropriate warranties for their protection. Specific warranties may be sought by the buyer to address concerns around the impact of Covid-19 on the business of the target, and also to prompt disclosure and allocate Covid-19 risk to the seller.
Decisions have been made largely on the basis of liquidity issues, valuation concerns, regulatory changes, and other practical aspects relating to lockdowns
Additional areas for seeking warranty protection by the buyer may include financial performance and accounts; business continuity and operations; solvency risk; performance or termination of material contracts; government stimulus; and employee rationalisation.
This would in turn require sellers to analyse whether they can give such additional warranties, and caveat the warranties in terms of thresholds, qualifiers and specific disclosures via disclosure letter. Sellers may also try to negotiate a deal where business interruptions due to Covid-19 do not fall within the ambit of breach of warranty. While ‘bring-down’ of warranties at closing is fairly common in India, sellers may now look to put materiality qualifications on bring-down of warranties to limit the potential walk away right of the purchaser as a result of updated disclosures.
Warranty and indemnity (W&I) insurance is not a widely used product in M&A transactions in India. The scepticism around W&I insurance is largely down to a lack of awareness around the benefits of W&I insurance and the perceived high premium costs, as well as the seemingly reduced coverage on account of the standard exclusions. In addition, very few insurance companies are offering W&I insurance as a product in India, and the limits for M&A transactions in India are not easily available.
W&I insurance is usually taken out only for high-value or sophisticated transactions, especially where the seller is a PE investor. Early on in the pandemic situation, W&I insurance policies were seen with wide exclusions pertaining to Covid-19. However, as things stand and progress, the exclusions are likely to become more specific and narrowed down for the policy coverage to make any commercial sense to the parties and be more acceptable.
Long stop date
Standard and specific conditions may be impediments towards a timely closing. These conditions could range from housekeeping or secretarial procedures to obtaining government approvals. Based on the nature of the condition to be completed, the timeline could be extended due to government and other offices not working to their full staff strength due to work-from-home guidelines. In such a case, it becomes important to factor in this uncertainty and provide flexibility in terms of a long stop date, which is the hard date by which the transaction either gets completed or is off the table.
As an alternative, in some situations where the same is suitable, parties may not incorporate the concept of a long stop date - however, in such a situation, looking into how the valuation and pricing is adjusted assuming the deal closes much after the notionally expected deadline is an essential factor for parties to discuss beforehand in order to avoid a standstill at a later date.
Change in law
New measures are being announced by the government on a regular basis to support and protect businesses due to the current pandemic situation, and also to ensure minimal disruption to the economy. These changes may not always be in line with the intended transaction structure that has been agreed between the parties. For such situations, consensus relating to risk allocation on account of a change in law must be suitably documented in the definitive agreements, in order to avoid ambiguity and a potential dispute down the line.
Foreign direct investment policy: recent actions
Under the FDI regime, one of the most impactful changes has been restricting FDI from countries that share their land borders with India (bordering countries) with the intent to curb opportunistic takeovers of Indian companies by persons or entities of such bordering countries. This move was widely seen to be targeting incoming investments from China. With China being one of the larger investors in India up until now, it is reasonable to believe that this measure will influence various aspects of M&A in India (and perhaps outside), in terms of existing FDI entities, deals that were in the making, and exit structures. The restriction is however limited to investment through the FDI route, and does not seek to regulate investment from foreign portfolio investors.
A few other recent changes in the FDI regime include opening up of the insurance intermediary sector up to 100% under the automatic route, permitting 74% FDI in defence manufacturing under the automatic route, changes in conditions applicable for FDI in civil aviation - which includes inter alia the exception carved out for non-resident Indians for investing up to 100% in Air India Limited - and opening up of the coal sector such that the sale of coal and coal mining activities including ‘associated processing infrastructure’ would now be under the automatic route for FDI, of course subject to other domestic laws on the subject.
What the future holds
Covid-19 has brought the world economy to a halt. With some businesses shutting down and many struggling to meet their general fixed costs sans revenue, the trickle-down impact is affecting dealmaking too. The pandemic has resulted in a large drop in the M&A space - even bigger than that during the 2008 financial crisis. However, on a very base level, it is also agreed that the workaround and impact of the 2008 financial crisis, while in numbers may have been similar, in terms of recovery is poles apart.
The scepticism around W&I insurance [in India] is largely down to a lack of awareness around the benefits and the perceived high premium costs
The direct impact of FDI regulation from bordering countries will of course mean fewer investments from China. As per recent reports, Alibaba, which had placed huge bets on Indian start-ups in the past, has put its further investments into India on hold. Due to the current global crisis, in terms of investment from persons or entities from bordering countries, exit structures may not be sustainable, as it would be a hard task to find buyers in the present market. This may have an adverse effect on M&A activity in India.
We believe that the M&A space will go through a significant recovery period to be back on track in terms of the growth that it was showing in the last few years. Players will go back to the drawing board in terms of structuring and restructuring deals that are imperative. Due to frequent changes in regulations, structures requiring as little government input as possible may be more favourable.
While on the face of it, the Covid-19 times have been incredibly difficult, there are still opportunities. The condition of various Indian companies at present can be best described as distressed. The pressure on otherwise good businesses has given rise to what we know as distressed M&A deals. These opportunities, being cast in terms of low valuations and distressed deals, may be a silver lining in the present circumstances.
Foreign parties looking to invest and make good out of distressed businesses must note that while many sectors have been liberalised, recently, India’s FDI policy underwent a change whereby persons or entities from bordering countries will require government approval for investing into Indian companies. However, for countries that do not share their land border with India, this restriction does not exist.
Key to Indian distressed deals right now is the disinvestment run that the government is currently on. Notably, Air India Limited has been on the market for a buyer for a few years now, with the government only further relaxing certain conditions to make the deal more interesting and lucrative. Opportunities are there for risk-takers.
In addition, with the Make in India and Atmanirbhar policies of the Indian government encouraging domestic businesses by inter alia providing regulatory relaxations and faster approval processes, foreign parties can look to get on an equal footing by acquiring existing Indian businesses. By doing so, such players can also eject the effect of levies and taxes that may be placed on foreign players doing business in India directly.
The aforementioned sectors that saw accelerated growth in the wake of the pandemic may boost M&A activity in India. Sectors like health-tech, ed-tech and fintech present tremendous potential and are likely to see increased interest from international players looking to expand their footprint into India, as well as due to consolidation by the larger private equity-backed local players.
L. Badri Narayanan
Lakshmikumaran & Sridharan
Badri practices in the areas of corporate, investment and tax laws. He regularly advises various leading Indian and multinational corporations on mergers and acquisitions, business transfer agreements (slump sales), joint ventures and share acquisitions, and has been involved in both domestic and cross-border transactions. Badri advises on various issues involving consortiums and joint ventures such as contract manufacturing scenarios, valuation, secondment, royalties and license fee arrangements. He holds a law degree from the University of London and obtained his LLM from Cornell Law School, USA. He is admitted to practice in India and New York.
Lakshmikumaran & Sridharan
Gaurav advises investment and commercial banks, private equity funds, multilateral agencies and strategic corporate clients on a variety of domestic and cross-border transactions including acquisitions, joint ventures, foreign investments and corporate restructuring, involving extensive advice on general corporate law and foreign exchange laws as well as the attendant regulatory issues. An alumnus of National Law School of India University (NLSIU), Bengaluru, he has 12+ years of experience working as a transactions lawyer for clients in diverse sectors including IT-ITeS, renewable energy, e-commerce, manufacturing, FMCG and food and Agri, financial services, technology start-ups, hospitality, real estate and logistics.
Lakshmikumaran & Sridharan
Kunal focuses on advising clients in relation to M&A transactions, private equity/ venture capital investment transactions, joint ventures and real estate transactions and has been involved in both domestic and cross-border transactions. Kunal also has significant experience in advising clients on company law, corporate compliance, entry strategies and setting up of business, employment laws and exchange control regulations in India. He is an alumnus of the Symbiosis Law School, Pune and has advised clients engaged in various sectors including automobile, IT/ ITES, technology, media, healthcare, financial services, real estate and manufacturing.
The authors would like to thank Gunmeher Juneja, principal associate and Pooja Vijayvargiya, principal associate for their assistance.