India: Private Equity

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This country-specific Q&A provides an overview to tax laws and regulations that may occur in India.

This Q&A is part of the global guide to Private Equity. For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/practice-areas/private-equity/

  1. What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?

    Investments by financial sponsors have been a consistent alternate source of investments in Indian markets. Potential growth opportunities coupled with several Government initiatives, such as, Skill India, Make in India and others have opened up additional investment avenues for funds. Private Equity firms invested $23.8 billion in 2017 making it the biggest year for private equity investments in India. The investment value is 39% higher than the previous high of $17.1 billion (recorded in 2015) and 55% higher than the $15.4 billion invested during 2016 (Source: India Private Equity Trend Report 2018 from Venture Intelligence).

  2. What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?

    Financial sponsors negotiate hard to seek a clean exit, which means the possibility of extensive warranties is limited and the tendency is to limit them to ‘fundamental warranties’ (such as, title of shares, authority, capacity and no conflict). If the purchaser of shares is resident in India and the seller (financial sponsor) is an entity incorporated outside India, the negotiations on tax warranties and indemnities tend to take more time and on many occasions the preference is to seek a non-recourse W&I insurance policy. Also, unlike a transaction involving a trade seller, the financial sponsor backed company does not prefer post-closing adjustments or hold back structures.

  3. On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?

    In relation to transfer of shares, the primary questions that would need to be addressed would involve examining the place of residence of purchaser and seller, the sector in which the target company operates, and process set out in the charter documents of the target company. The final process of transfer would depend upon the answers to these questions.

    In a private limited company, the shares are usually held in physical form and would require execution of a prescribed form by the parties. Such form is then stamped @0.025% of the transaction value and submitted to the target company for registration. The board of the target company approves the transfer and records the same in a statutory register called “Register of Members”. The physical share certificate is then returned to the new owner with a noting on the share certificate with its name.
    The shares in public companies are statutorily required to be in dematerialised form. The depository agent records the transfer in its books and issues a ‘benpos’ (beneficial ownership) statement reflecting the name of the transferee. The transfers are completed by an executed ‘depository slip’ deposited by the seller with its depository agent along with details of the demat account of the purchaser, number of shares transferred, etc. There is currently an exemption available for payment of stamp duty on transfer of shares in dematerialised form. However, there is a proposal to do away with this exemption and levy a nominal stamp duty on such transfers.

    Additionally, the share purchase / subscription agreement executed by the financial sponsors with the seller / target company is also subject to payment of stamp duty as a separate instrument (in addition to stamp duty on share transfer forms). The quantum of stamp duty on such agreements would depend upon the State in which the same is executed and retained. There is a proposal to have a uniform stamp duty on such agreements across India and also eliminate possibility of multiple stamp duty being imposed on a single transaction where it is implemented by executing multiple different instruments / documents (example, in relation to shares it would be the agreement, share transfer forms, share certificate).

    Direct Taxes

    Securities transaction tax at the rate of 0.1% of the value, if settled by the actual delivery of shares, is payable in case of share transfers of a listed Company. Capital gains taxes along with applicable surcharges and cess under the (Indian) Income-tax Act, 1961 is payable in case of a share transfer. However, the specific rates and the time of payment/withholding will depend on the jurisdiction and residency of the transferor.

  4. How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?

    Usually, the financial sponsors will provide letters of comfort (in case of equity financing) or copies of sanction/commitment letters of the debt financiers (in case of mezzanine financing) as comfort to the sellers. In some occasions, the purchaser has also sought comfort from limited partners and the asset management company for the financial sponsors. In case of exit transactions, the funds prefer supporting the warranties by providing a non-recourse W&I insurance policy.

  5. How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?

    The locked box pricing is a favoured mechanism by selling financial sponsors. This not only allows them a clean exit but also an ability of avoiding any ambiguity or call backs post distribution of the proceeds to their limited partners. Post-closing adjustments / hold backs are not very popular and where required they are negotiated and detailed to specific matters required to address any valuation differences or matters arising out of the due diligences.

  6. What are the typical methods and constructs of how risk is allocated between a buyer and seller?

    Risk mitigation and allocation is generally done via warrants, general and specific indemnities and disclosure of specific facts as carve-outs from any general indemnities. Purchasers also use MAC clauses for mitigating uncertainties during the period between signing of the transaction agreement and closing of a transaction especially if theinterim period is long.

    Warranties typically cover fundamental warranties, compliance with law, statutory consents and filings, tax and accounts, ESG and labour, and litigation related warranties. It is common to disclose facts/liabilities set out (a) in the audited accounts (which are publicly available) as a general exception to warranties and (b) in a specific detailed manner in a disclosure letter as a specific exception. It is rare that information in data-room is considered as an exception to the warranties.

    Indemnity provisions are detailed in the Indian context and typically cover aspects of which party will control third party claims as well limitation of liability. Usually, M&A transactions in India, have time as well as monetary limitations of liability.

    Time limitations for indemnity for fundamental warranties is either a very long period or linked to the statutory limitation period. Time limitation for tax warranties is usually 7 years from the closing and for other warranties can be between 18 months to 36 months (based on the risks identified in the due diligence exercise).

    Monetary limitations include de-minimis, basket provisions and aggregate caps on liability. All of these are usually very specific, based on the facts of a transaction. The aggregate caps on liability range from 10% to 100% of the total consideration - based on the quality of the documents/information provided in the due diligence exercise as well as the seriousness of the risks identified in such exercise.

    Specific indemnities are usually related to specific regulatory non-compliance risks affecting the core business, environmental issues, on-going litigation and taxes. Separate monetary limitation and time limitation are agreed for specific indemnities.

    MAC clauses allow the purchaser to terminate the transaction documents if there is a material negative impact on the target company during the period between signing of the transaction documents and the closing of the transaction. MAC clauses exclude general economic and political changes but can include regulatory changes which are specific to the industry/business of the target company.

    In terms of dispute resolution, careful assessment of factors must be taken into account while choosing inter alia the seat of arbitration, exclusion (if any) of Part I of the Arbitration and Conciliation Act, 1996 and the lex arbitri. Impact of such choices can be critical to the efficient resolution of disputes. In our experience, institutional arbitration has proven to be cost-effective as opposed to ad hoc arbitration. Also, expert determination, if any, must be clearly demarcated from the disputes resolution clause. It is also advisable to ensure that the exclusive jurisdiction clause must be subjected to the disputes resolution clause to prevent any protectionist court from assuming jurisdiction over disputes.

  7. How prevalent is the use of W&I insurance in your transactions?

    W&I are not very common in India, especially due to the upfront cost and probably a fact that enforcing indemnities and recovering the claims takes longer in the Indian context. However, in the last 12 to 18 months parties have actively evaluated W&I insurance and we see it increasingly being used in the transactions.

  8. How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?

    The share of private investments in the infrastructure sector have fallen to a decadal low of around 25 per cent in FY18 steeply down from a high of 37 per cent in FY08 (Source : https://economictimes.indiatimes.com/news/economy/indicators/private-investments-in-infra-plunge-to-25-in-this-fiscal-report/articleshow/66088568.cms).

    Investment in public listed companies is made under a popular ‘foreign portfolio investor’ route. Investment by private equity funds in public listed companies is not very common, but investments in companies just before they get listed (as pre-IPO investment) is gaining more popularity.

  9. Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?

    Generally, a substantial majority of the industry sectors are permitted to receive foreign investment without requiring governmental approval. However, there are minimum pricing requirements to be adhered under Indian foreign exchange laws based on the Indian/non-Indian residential status of the purchaser and the seller.

    Sectors such as lottery/gambling, real estate and manufacturing of tobacco products are prohibited from receiving foreign investment.

  10. How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?

    Merger clearance is agreed as condition precedent to closing of a transaction in the transaction documents and the risk is passed on to the acquirer. If the financial sponsor has portfolio companies which are in competing business as the target company, it may result in a detailed review by the merger control authorities.

  11. Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?

    Minority investments by financial sponsors are typically structured as equity investment either as straight equity or an instrument which is compulsorily convertible into straight equity; minority protections are usual and include board representations, quorum requirement, information rights, veto or consultation on key business related decisions and capital raising decisions, appointment of independent directors, right of first refusal/tag along right, drag along rights and, put options.

  12. How are management incentive schemes typically structured?

    It is usual to structure such incentives through employee stock options or phantom units. Employee stock options usually result in equity shares being issued to the management based on a pre-agreed vesting schedule whereas phantom units carry only economic right in case of a pre-agreed exit event.

  13. Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?

    There are specific tax rules which govern the taxation of employee stock options, wherein the value of the employee stock option less the amount paid by the employees is regarded as a “perquisite” and taxed under the head “salary” in the hands of the employees at the time of exercising the stock option. The Employer is obligated to withhold taxes at the time of exercise of the options. Capital gains shall be levied on the employee on sale of shares allotted pursuant to the stock option scheme.

  14. Are senior managers subject to non-competes and if so what is the general duration?

    Whilst non-compete clauses during the term of the employment are recognised under Indian law, post-employment period non-compete clauses have more conditions and tend to have difficulty in being enforced. Nevertheless, it is common to have non-compete clauses during and post-employment. Typically, post termination non-compete clauses are between 6 to 18 months.

  15. How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?

    Financial sponsor has board nomination rights, veto rights and information and inspection rights in a portfolio company.

    Board nomination rights are standard for minority investments. Indian company law casts fiduciary and statutory duty on every director of a company to act in its best interest and, by implication, disregarding the interest of the nominating shareholder.

    Veto right over material business decisions are standard in the Indian context; this right is structured in the form of a prior consent of the financial sponsor as an entity and not as consent of the financial sponsor’s nominee on the board of the portfolio company. The rationale for such structure is due to the fiduciary and statutory duty of a director as stated above. In context of public listed companies and transactions involving anti-trust approvals, receiving such affirmative rights for the acquirer are limited because of the regulatory implications.

    Information and inspection rights are also standard in the Indian context; these include periodic disclosure by the portfolio company with respect to accounts and financial information, customer contracts, resignation by key managerial personnel, budgets and business plan. Inspection rights to examine the books and records as well as meet the key managerial personnel of the portfolio company are usual and at the cost of the financial sponsor.

    The above rights are recorded in investment agreement or a shareholders’ agreement and, for the purposes of enforceability are required to be recorded in the articles of association of the target company. It is important to note that articles of association of the portfolio company are filed with the Registrar of Companies and are publicly accessible.

  16. Is it common to use management pooling vehicles where there are a large number of employee shareholders?

    Management buy-outs are not common in the Indian context; if the employee shareholders do intend to undertake a management buy-out pooling vehicles are used.

  17. What are the most commonly used debt finance capital structures across small, medium and large financings?

    The most commonly used debt financing options are as below:

    1. Long term loans from banks. This option is a suitable option across small, medium and large funding requirements. However, the end use of loan under this option is highly regulated and banks in India are not allowed to lend for land acquisition, capital market transactions, acquisition of own shares by the borrower, subscription to or purchase of shares/debentures, including that of subsidiaries /SPVs, etc.
    2. Long term loans from Non- Banking Finance Companies. This option is again a suitable option across small, medium and large funding requirements. It is however a costlier option in terms of interest rate(s) as compared to loan from banks. Further, most of the end use restrictions that are applicable to loan from a bank are not applicable to loan from a Non- Banking Finance Company.
    3. External Commercial Borrowing (ECB) from offshore lenders– ECB can be availed in the form of bank loans, loans from foreign equity holders, floating/ fixed rate notes/ bonds/ debentures (other than fully and compulsorily convertible instruments), trade credits beyond 3 years, foreign currency convertible bonds, foreign currency exchangeable bonds, etc. ECBs are highly regulated in terms of eligible lender, eligible borrower, end use, all in cost ceiling. Some of the end use restriction for ECBs are (a) Real estate activities, (b) Investment in capital market, (c) Equity investment, (d) Working capital purposes except from foreign equity holder, (e) General corporate purposes except from foreign equity holder, (f) Repayment of Rupee loans except from foreign equity holder, (g) On-lending to entities for the above activities.
    4. Issuance of non-convertible bonds (listed or unlisted) which are subscribed by financial institutions and foreign portfolio investors are subject to compliance with relevant guidelines of the Reserve Bank of India and the Securities and Exchange Board of India, as applicable. This option is also subject to compliance of deposit regulations under the Companies Act, 2013. This option is more suitable to medium and large funding requirements.
  18. Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?

    A company is not permitted under Indian law to finance acquisition of its own shares. However, the holding and group companies are permitted to provide corporate guarantee and security of their assets, subject to certain compliances.

  19. For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?

    Standard form of credit agreement is typically used by banks and financiers and these are usually LMA/APLMA standard agreements. Some banks and financial institutions also have their own formats that are standardised either internally or externally by an empanelled Lawyer/Law Firm.

    Initially standard forms are customised to fit in the commercial terms agreed between the lender and the borrower. Thereafter, the document is mostly negotiated for restrictive covenants, representation, events of default and indemnities. Materiality of the level of discussion depends on the borrowing entity. Lenders generally want to stick to the standard forms and are reluctant to dilute the standard clauses.

  20. What have been the key areas of negotiation between borrowers and lenders in the last two years?

    The key negotiating terms are the financial / negative covenants (such as, debt:equity ratio, change of control, restriction on merger/amalgamations, restriction on change in control, anything affecting capital structure), event of defaults and consequences, indemnities and manner of securing the finances. It is also common to provide a detailed use of funds, monitoring mechanisms and creating specific bank accounts for collecting funds and re-payment of loans.

  21. Have you seen an increase or use of private equity credit funds as sources of debt capital?

    In recent years, we have seen an increasing trend for private equity debt funds being registered as alternate investment funds under the SEBI Category III. Such funds tend to be sector focused, for example, real estate, alternate energy, health care.