Exit mechanism trends in private equity transactions in India
September 2013 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
A successful exit with a healthy rate of return is the objective of every private equity (PE) investment. In the economic conditions that have prevailed over the past two years, PE funds have found achieving a successful exit for their India investments a challenge. As per a recent survey of the Indian market by Bain & Company, more than raising capital or finding the right investee, the bigger challenge for PE funds has been to achieve a successful exit. In this context, an analysis of the exit modes and the variables involved therein gains significance.
Initial public offers (IPOs) have traditionally been the favoured mode of exit for PE funds. However, with capital raising through capital markets in India remaining subdued in recent years, PE funds have been forced to explore other modes of exit. In 2012, exit via an IPO was the least preferred route, being undertaken in only 3 percent of the total PE exits, according to KPMG India.
A ‘put option’ has traditionally been a standard element negotiated as part of modes of exit contemplated in investment agreements – this can be a fixed return arrangement or a fair value arrangement. Technically, whilst put options can be entered into in cases of shares of private companies, challenges arise in the context of enforceability of put options in cases of shares of public companies on account of the provisions under the Securities Contracts (Regulation) Act, 1956 (SCRA). Further, the approach of the Indian Central Bank to categorise instruments with built-in ‘options’ specifically with definite returns as ‘foreign debt’ rather than ‘equity linked investment’, has whittled the nature of put option arrangements that can be entered into by a foreign PE. That said, the Bombay High Court in a recent decision has sought to deal with the previous controversies on the nature of option arrangements, and as such upheld validity of such arrangements from an SCRA perspective – although for technical reasons this is not yet a prevailing view, and there have been press reports about the Government of India taking steps to clarify the framework within which put options and call options will be enforceable.
A buyback of the PE fund’s stake by the investee company is another common mode of exit contemplated in investment agreements. Buybacks are a company initiated mode of exit per the provisions of the Companies Act, 1956, and pursuant thereto are also subject to regulation with respect to the extent of funds that can be made available for such buyback and the quantum of buyback. Buyback arrangements thus face practical difficulties in implementation, especially in companies which are not cash rich. In practice it is usually implemented only through fresh funds obtained by new investment in the investee company.
In some transactions, personal guarantees are issued by individual promoters in favour of domestic PE funds, to guarantee their investment returns. This is generally extended in cases where the individual promoters are not direct shareholders of the target company. The personal guarantee, however, has its own limitations and enforcement may also involve extended litigation.
Secondary sales to third parties have been the most popular mode of exit in the recent past. PE funds with a fixed fund life are forced to liquidate their stake in investee companies even though an IPO may seem viable in the relatively near future. They thus look to make their returns by selling their stake to other PE funds which are looking to disburse funds and have the luxury of waiting for a few years to make their returns. In this context, complications can arise in the event some of the existing investors are continuing in the investee company. This is also because the investee company and the exiting investor invariably have to overcome the hurdle of matching the investment rights of the new investor with that of the continuing investors.
Trade sales (i.e., sale of a controlling interest to a strategic buyer) by exercise of a drag right by the PE fund would need active cooperation by the promoters. Some PE funds seek to secure the enforcement of such drag along rights by using an escrow arrangement whereby a part of the promoters’ shareholding is taken out of their control by depositing the shares in escrow and the escrow agent is authorised to sell such shares upon the occurrence of a trigger event. However, investors are not sanguine about such an arrangement which supports the drag right of a foreign investor, since the regulators may consider such an arrangement as creation of security in favour of the foreign investor.
With the traditional modes of exit described above facing practical difficulties in light of regulatory and market conditions, PE funds are looking at new and innovative ways to achieve a successful exit. Some of the modes of exit that are being explored, are: (i) a share swap (upon receipt of necessary regulatory approvals) with a listed entity forming part of the same group as that of the investee company, wherein the acquired shares are capable of being easily liquidated is one indirect way of achieving an exit; or (ii) PE funds negotiating the right to require the investee company to sell its assets or its business as a going concern, in order to obtain liquidity – depending on the ownership distribution of the investee company, this may require support from other shareholders.
Most of these modes of exit, at a practical level, do entail cooperation from the promoters. Perhaps to counter balance this ‘promoter risk’ there has been an increasing interest in evaluating investments in certain classes of listed companies as private investment in public equity (PIPE) transactions wherein, although the PE fund cannot obtain participation in control rights without making a tender offer, the PE fund has the additional comfort of easy liquidity, as their shares can be freely traded. Consequently, a substantial portion of the cumulative PE funding in the past year was through PIPE deals.
A holistic and practical approach by PE funds towards investment and returns, and promoter identification and promoter relationship management would be key drivers for a successful exit. On the part of the promoters, their proactive participation in the exit, with the understanding that a successful exit for the investor would attract better investments in the future, would enhance investor confidence.
Srinivas B.R. is a partner, Karan Ajitsaria is a manager and Sharan Balasubramanian is an associate at Dua Associates. Mr Srinivas can be contacted on +91 9880201153 or by email: firstname.lastname@example.org. Mr Ajitsaria can be contacted on +91 98867 27841 or by email: email@example.com. Mr Balasubramanian can be contacted on +91 99002 17887 or by email: firstname.lastname@example.org.
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Srinivas B.R., Karan Ajitsaria and Sharan Balasubramanian