Private equity (PE) transactions in India conventionally comprised minority investments in Indian companies. However, maturing market conditions and an increasingly favourable regulatory landscape have been providing tailwinds to PE firms to undertake buyout transactions. Many PE firms investing in India have gained significant experience to deal with the governance and regulatory risks that Indian markets pose. This enables them to leverage their expertise from running businesses globally to managing businesses in India.
Sources indicate that buyouts contributed to 25% of all investments made in India over the last 3 years. Buyout transactions offer PE firms control over the management, capital structure and exits. . Such investments, targeting sectors like real estate, IT services, financial services, technology and telecom, are on the rise. Public sector banks and large conglomerates offloading their non-core assets due to stressed balance sheets, and undertaking recalibrations to focus on principal business activities have thrown the doors open for PE firms to explore interesting opportunities. Increased operational efficiency and market shares have also been driving consolidation activity in the Indian markets (e.g, Walmart acquiring Flipkart and the Capital First –IDFC merger). The Insolvency and Bankruptcy Code, 2016 has also been an enabler for PE firms to acquire valuable assets that will go under the hammer at attractive valuations.
PE firms executing control transactions have driven a shift in the typical mechanisms that are involved in deal making in India, getting it closer to global market standards. Transactional insurance, or representations & warranties insurance (R&W Insurance) coverage has emerged as an important alternative to potential indemnity obligations of PE firms undertaking divestments, as it provides them with a ‘clean exit’ opportunity. R&W Insurance providers undertake a limited review of the due-diligence documents and the deal documents to carve out exclusions to the R&W Insurance policy, which would typically be risks that were identified during the due-diligence process but have not been adequately ring-fenced / provided for in the deal documentation.
In buyout transactions, PE firms that are controlling an Indian company may be required to undertake indemnification obligations (backing the representations and warranties) to the acquiring PE firm, including on the business and past operations of the company.
Concerns around the fund lives of PE firms’ investment vehicles, which limits their ability to backstop indemnification payment obligations, along with uncertainties on the quantum of taxes that are payable on the capital gains incurring on the selling entity (to be withheld by the acquiring entity prior to making payments to the selling entity, and deposited with the Indian tax authorities) have driven PE firms to consider escrow mechanisms in the deal mechanics. Additionally, any limitations arising from the R&W Insurance coverage (exclusions like due-diligence findings, specific indemnity items, data privacy breaches, transfer pricing issues, and in certain cases, fraud by the selling entity) can also be sought to be covered by escrow amounts. As the buying entity and the selling entity would be non-Indian entities, Indian laws do not prescribe any restrictions on size and duration of the escrows maintained outside India.
With respect to indemnity enforcement, owing to the uncertainties and the time involved in litigation in Indian courts, PE firms can agree for separate portions of the deal documents to be governed by laws of different jurisdictions. The process governing the transfer of securities between the PE firms will be in accordance with Indian law as the securities relate to an Indian company. However, the representations and warranties on the sale, and the indemnity provisions backing the representations and warranties can be governed by the laws of a foreign jurisdiction which has more favourable enforcement mechanics.
Non-Compete: In cases of control transactions involving a complete exit by the promoter(s), it is critical for PE firms to execute non-compete contracts with the exiting promoters. However, enforcement of non-compete contracts governed by Indian laws are heavily dependent on the terms and conditions of the contracts, and in most scenarios as Indian courts do not view non-compete contracts favourably. The Indian anti-trust regulator has provided that the restrictions under non-compete contracts ‘should not exceed what is reasonably required’.
Typically, restrictions under non-compete contracts in India survive for periods of up to 3 years, except in deals involving certain industries / sectors or involving cases where customer loyalty to the selling promoter may persist for longer durations, or the nature of the know-how transferred justifies an additional period of protection. If the promoter(s) are non-Indians, the non-compete contracts can be governed by the laws of a foreign jurisdiction which has more favourable enforcement mechanics. Alternatively, the ‘split governing law’ mechanism can be adopted, with the non-compete provisions of the deal documents being governed by the laws of a foreign jurisdiction which has more favourable enforcement mechanics.
Escrow mechanisms: R&W Insurance coverage is not a common alternative to indemnity obligations of promoter(s) in case of buyouts by PE firms, and escrow mechanisms are still favoured as a source of potential indemnity payouts by the promoter(s). However, implementing escrow arrangements in India for a duration greater than 18 months and/or a size in excess of 25% of the deal consideration would require the prior approval of the Reserve bank of India (RBI), the Indian central bank (RBI). Separately, only banks authorized by the RBI are permitted to hold documents in escrows in India.
Professionalizing the management: In cases of buyouts where the promoter(s) are partially exiting, the smooth operation of the management of the target entity would be key to value creation post deal completion. As the promoter(s) continue to remain associated with the target entity post deal consummation, the PE firm’s role as the majority controlling stakeholder and operational freedom of the minority promoter(s) for day-to-day activities would have to be adequately balanced.
It would be critical for the PE firm to on board the promoter(s) on the investment goals of the PE firm and the manner in which the firm proposes to – ‘operate and manage the target entity post the deal consummation (including steps that may be taken to professionalize the target entity’s operations). PE firms also conduct seminars / training sessions with the employees of the target entity to sensitise them of the proposed ‘cultural’ changes, and to align the vision and expectations of the incoming management with those of the employees.
Management succession plans: PE firms exercising control over a company but lacking the requisite operational / management wherewithal would have to depend on the minority promoters to operate and manage a business. PE firms should formulate and implement management succession plans to phase out the promoter’s involvement in the business while involving their operations teams to work with the promoters to understand the nuts and bolts of the business and operations of the target entity. The management succession plans should clearly identify the management team (which balances investor and promoter interests during the transitory phase) which would succeed the board of directors (and other management committees) following a departure of the promoters.
Employment contracts: PE firms tend to execute contracts with the promoter(s) and certain key members of the top management involving their roles and responsibilities following deal consummation. Such contracts may also contain milestone linked payment mechanics, or other forms of earn-out structures (or incentive fee arrangements) that provide the promoter(s) a ‘cash-out’ if the PE firms exit with handsome returns.
Inter-se rights: The inter-se rights of the PE firms and the minority promoters, including governance rights, will be dependent on whether the target entity is proposed to be operated like a ‘joint-venture’ or an investor run company. If the promoters are treated akin to minority financial investors, they may seek affirmative rights on certain governance aspects which may lead to decreased operating flexibility of the target’s board.
PE firms undertaking buyouts will have to determine the taxes on capital gains that arise pursuant to the sale. They are also are required to withhold such amounts from the consideration payable to the selling non-resident shareholder and deposit such amounts with the Indian tax authorities and undertake certain regulatory filings. PE firms should evaluate the transaction {and past transactions or restructurings (if any) undertaken by the portfolio company prior to the buyout} from the perspective of the general anti-avoidance rules, which is a set of anti-tax avoidance regulations prescribed by Indian tax laws. PE firms are now mindful while structuring management and control rights of offshore subsidiaries of Indian portfolio companies so that the subsidiaries are not treated as Indian tax residents on account of ‘place of effective management’ being in India. Increasingly, specific indemnities are being required for claim for tax exemptions under the relevant tax treaty by the selling shareholder.
Buyouts by PE firms will continue to gain momentum, both in terms of value and volume, over the coming years. Boosted by evidence of successful exits by PE firms on their earlier buyouts, global blue-chip PE firms, and even mid-sized PE firms are continuing to evaluate buyout opportunities in the Indian market. However, certain ‘softer-aspects’ of deal making would have to be resolved for buyout activity in India to touch its true potential.
