Private Equity Investment and its Regulation

Introduction

Private equity investment refers to the investments made by private equity firms, venture capital (VC) firms or an angel investor. Each of these types of investor has a different goal and employs different investment strategies but they all provide capital to a company to aid its growth or satisfy working capital requirements.

Venture capital firms provide funds to nascent businesses that they deem to have high growth potential. They invest in these early-stage companies (usually based on an innovative technology) in exchange for an ownership stake. They take this risk hoping for the company to be successful and earn a return through an eventual exit via an initial public offering (“IPO”) or a trade sale (merger & acquisition). Due to the high level of risk involved in such investments, venture capital investments are often prone to failures.

Angel investors are usually high net-worth individuals who basically do the same thing a VC firm does but with their own funds instead of pooled money. These types of investors have greatly increased over the years.^[1] This increase demonstrates the attractiveness of investing in equity over other traditional forms of investment.

Private Equity firms are mainly interested in acquiring private companies that have not been listed on a stock exchange through equity investments and restructure it before selling it again hopefully at a high return on equity. Private equity often makes extensive use of debt to finance its acquisitions which allows them to generate high rates of return on equity. For e.g., if an acquisition is financed 20% through a private equity fund and the rest 80% through debt. An increase of 20% in the value of the company will generate a 100% return on equity. However, if the company fails to recover/grow then the losses shall be equally large. However, the debt 80% debt is often collateralized against the assets of the firm being acquired rather than the assets of the private equity firm, therefore, if the investment goes south at most the private equity firm will lose the 20% it invested. This was an example of a leveraged-buyout strategy employed by most private equity firms. There are, however, other strategies that a private equity firm could also employ in their investing.

These investments are often described as ‘ill-liquid’ since there is no secondary market for them and the investors are considered patient due to the long-term nature of these investments.

Venture Capital and Private Equity

The ambiguity between private equity and venture capital funding has existed for a long time. Venture capital can be thought of as a subset of private equity. Both of these investments are sometimes used interchangeably due to the confusion that occurs, since both refer to firms that invest in companies and earn by exiting and selling their investments, usually through Initial Public Offering (IPO). However, there are several differences between PE and VC firms. A Venture Capital firm usually invests in start-up funds. They make small investments in various companies, across several sectors. This is because investing in a start-up is a risky step and there are always chances of failure. By spreading the investments across several companies, the risk is minimized. On the other hand, Private Equity firms put in huge investments in mature companies, to mitigate the risk of failure. A huge investment ensures a majority stake for the Private Equity firm and they work closely with the company to increase value and wealth.

Further, Private Equity firms usually invest in unlisted companies. These firms gain control over publicly traded companies with the intention of taking them privately by delisting the company from the stock exchange. Whereas, Venture Capitalists invest in start-ups and early-stage companies that have the potential to grow.  Another difference between the two types of investments is the kind of companies they invest in. While PE firms spread their investments across all sectors, VC funds usually focus on technology, biotech and clean-tech companies. Lastly, PE firms use a combination of equity and debt in their investments, unlike VC firms that deal only in equity.

Despite all the confusion surrounding both the terms, it is important to look closely while choosing the type of investment. There can be several distinct differences between both the forms of funding when it comes to exiting and raising money.

Private Equity

“Private equity” does not have a universally accepted definition but is generally understood as a rebranding of leveraged-buyout firms. The term has come to be used to describe the business of taking a company into private ownership and restructuring it before selling it again at a profit. It is for this reason that PE firms are considered “financial buyers” as opposed to “strategic buyers.” The latter is usually a horizontal or vertical integration aiming to benefit from the synergies and less concerned about the company’s potential to generate quick returns.

Private equity operations generally have a private equity manager who uses the money of the investors along with utilizing considerable amounts of debt to acquire firms with an aim to restructure them and sell them at a profit. The investors usually comprise wealthy individuals, corporations, sovereign wealth funds, hedge funds, other private equity firms etc.

Private equity firms unlike mutual funds have a smaller number of investments and they control each one of their investments. They take these companies into private hands and often completely revamp the management. They are heavily involved in the operations of the business to make it profitable. And for this reason, the investors have a much longer time horizon. Private equity funds usually have a lifetime of 10-12 years. This is also what sets them apart from hedge funds who typically make shorter-term investments with no control or influence and bet on both the up and the downside of a business or an industry.

According to industry magazine Private Equity International, the biggest private equity firms in 2020 include Blackstone, The Carlyle Group, Kohlberg Kravis Roberts and TPG Capital.^[2]

Investment in private equity is usually of the following types:

• Seed financing: where capital is provided to develop the business idea in exchange for an equity stake.
• Start-up financing: where capital is provided to help the new business grow.
• First-stage: where capital is provided for the commercialization and production of products. The funding at this stage is larger than the previous stages.
• Second-stage: where the second round of capital is infused for production, working capital and other requirements of the business.
• Third-stage: where capital is provided for the expansion of the business.
• Bridge financing: where the capital is provided to carry out an IPO or an M&A. This is often the final stage of investment for a VC firm.
• Leveraged Buyout (LBO)/ Buyout: where the capital and usually debt is used to acquire the entire business or a controlling stake.
• Management Buyout (MBO): where capital is provided by the investment firm along with the incumbent management to acquire a controlling stake in the business.

(A private investment in public equity, often called a PIPE deal, is also a type of investment undertaken by private equity firms. However, the investment there is not into the private equity of a company but public equity which is why it has been left out of the above list.)

Participants in the private equity market.

Primarily there are three categories of participants in the private equity market, these include: Issuers, Intermediaries, and Investors.^[3]

• Issuers are the firm/business which is looking for the private equity investment. This could include a new start-up looking for an investment to grow the business or a mature and struggling company looking to expand or change its capital structure.
• Intermediaries are the VC firms and private equity firms themselves.
• Investors are the contributors of capital to the VC/Private equity firm.

Structure

The typical structure of a Private Equity Fund has been illustrated below:

The SEBI (Alternative Investment Funds) Regulations, 2012 as amended on March 6, 2017 defines a private  equity  fund as an  Alternative  Investment  Fund  which  invests primarily  in equity  or  equity  linked  instruments  or  partnership  interests  of investee companies according to the stated objective of the fund.^[4] These funds typically have two types of partners: general partners and limited partners. A private equity firm is the general partner, it has managerial and financial powers, and is responsible for the day-to-day operation of the limited partnership. It charges a management fee for all this work along with a carried interest which is a percentage of the profits that the fund gains on investments. The limited partners are institutional investors such as pension funds, insurance companies, endowments, and fund of funds, or from high net worth individuals, sovereign wealth funds, hedge funds, or banks. Their role is limited to providing the capital to the fund which is then managed by the private equity firm.

Exit Strategies

Generally, a private equity firm will raise capital from investors through a private equity fund. This fund shall be utilized along with the use of leverage to acquire a controlling position in a company. After growing the company and maximising the value of their investment, the Private equity firm shall exit their investment through one of these avenues:

• an initial public offering (IPO) — by offering shares to the public. However, this is pretty uncommon in recent private equity exits;
• a merger or acquisition — the company is sold for either cash or shares in another company. This is the most common way for private equity firms to exit;
• a recapitalization — business borrows money to fund a repurchase of equity allowing the private equity investors to exit;
• by liquidation- this is usually a last resort but when the company fails and there is no hope for recovery the investors have to settle for what they can.

Regulation

Domestic Funds

Alternate Investment Funds (‘AIF’)

Private Equity investment funds, Venture capital funds etc. fall under the broadly defined term Alternate Investment Funds (“AIF”). As per the SEBI (Alternative Investment Funds) Regulations, 2012 as amended on March 6, 2017^[5] the term AIF is defined as any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

This is a broad and inclusive definition which goes on to specifically exclude funds covered under the SEBI (Mutual Funds Regulations), 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.  The proviso to the definition further excludes:

♦ family trusts  set  up  for  the  benefit  of   ̳relatives‘  as  defined  under Companies Act, 1956;

♦ ESOP Trusts  set  up  under  the  SEBI(Employee Stock Option Scheme and Employee Stock Purchase Scheme), Guidelines, 1999 or as permitted under Companies Act, 1956;

♦ employee welfare  trusts  or  gratuity  trusts  set  up  for  the  benefit  of employees;

♦ holding companies‘  within  the  meaning  of  Section  4  of  the  Companies Act, 1956;

♦ other special purpose vehicles not established by fund managers, including securitization trusts, regulated under a specific regulatory framework; (vi)funds managed  by  securitisation  company  or  reconstruction  company which is registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; and

♦ any such pool of funds which is directly regulated by any other regulator in India.

An AIF is essentially a privately pooled investment vehicle which could be incorporated in the form of an LLP (e.g. private equity fund), trust (REIT write full form) or body corporate. The purpose of its creation is to collect funds from investors that may be Indian or foreign and invest the funds with a defined investment policy for the benefit of its investors.

SEBI has provided three categories to classify an AIF on the basis of its investment policy and the nature of the funds. These are Category I AIF, Category II AIF, and Category III AIF. Accordingly, a fund has to comply with the distinct set of conditions and rules put in place by SEBI.

• Category I AIF is for a fund which invests in start-up or early stage ventures, social ventures, or other sectors the government/regulator considers to have positive spill over effects on the economy and for which it might provide incentives or concessions. This is prominently targeted towards venture capital funds but also includes angel funds, SME funds, and such other AIFs as may be specified.^[6]

• Category III AIF is for a fund that employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. This largely includes funds interested in investing in listed securities such as hedge funds or other open ended funds for which the government/regulator provides no specific incentives. (cite s.3.4.c)^[7]

• Category II AIF is for a fund that does not fall into Category I or III and does not employ any leverage except to meet day-to-day operational requirements. This could include private equity and debt funds for which  no  specific  incentives  or concessions  are  given  by  the  government  or  any  other  Regulator (cite 3.4.b)^[8]

The cap on the numbers of investors pooling is 1000 and the sponsors/managers of the AIF are required to have a continuing interest in the AIF throughout its life. They also need to hold at least 2.5 percent of the corpus of investment or 5 crore rupees whichever is lower, and for a category III AIF at least 5 percent or 10 crore rupees, whichever is lower.

As per regulation 9 of the AIF regulations, all AIFs are to state investment  strategy,  investment  purpose and its investment methodology in its placement memorandum to the investors and any alteration to which can only be made with the consent  of  at least two-thirds  of  unit  holders  by  value  of  their  investment  in  the AIF.^[9]

The other general obligations, responsibilities and transparency requirements of AIFs are provided in Chapter IV of the AIF Regulations. In addition to these minimum requirements an AIF may also provide additional disclosures to its investors through the placement memorandum.

SEBI through its circular has made it mandatory for an AIF to also include a detailed tabular example of fees and charges applicable to the investor including the distribution waterfall.^[10] It has further put a cap on overseas investments by AIFs to the tune of 25% of the investible funds of the AIF and a maximum limit of USD 500 million.^[11]

Foreign Investors in AIFs

Foreign investors can also invest into a domestic pooling vehicle. The RBI has permitted such investment vehicles to receive investments from non-resident Indian investors and foreign investors through the automatic route, as long as control of the investment vehicles vests in the hands of sponsors and managers, or investment managers, that are considered Indian-owned and controlled under the extant foreign regulations; investments by Indian-controlled AIFs with foreign investment are thus deemed to be domestic investments.

Off-shore Funds

Offshore funds (i.e. investment funds organised outside India) are regulated by SEBI through its applicable regulations and by the Reserve Bank of India through the exchange control regulations, namely Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2017 (FEMA Tispro).^[12]

Investment route for offshore funds investing in private equity are:

Foreign Direct Investment

Foreign investors typically route their investment in private equity through an FDI vehicle. The annually issued FDI consolidated policy to regulate these investments along with the Foreign Exchange Management (Non-Debt Instruments) Rules 2019^[13] (the Non-Debt Rules) and FEMA Tispro Depending on the sector these investments were also required to gain approval from the Foreign Investment Promotion Board  which has now been abolished and replaced by an  online single-point interface where the concerned department of government concerned with the sector shall grant approval to the foreign investment proposals.

While FDI of up to 100 percent is permitted in most sectors in India under the ‘automatic route’ there are a few where it is prohibited or permitted with a threshold such as the Insurance sector. Prohibited Sectors include: Atomic energy, Lottery business, Real estate business or construction of farm houses, Trading in Transferable Development Rights, Gambling and betting including casinos / lottery business, and Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

Foreign Venture Capital Investor

In order for foreign investors to invest in VC undertakings they need prior registration with SEBI under SEBI (Foreign Venture Capital Investors) Regulations 2000^[14] (the FVCI Regulations). The process typically takes 20 to 30 days from the date of application. To promote job creation and innovation, the RBI allowed for 100 per cent FVCI investment in start-ups. The Non-Debt Rules also allow FVCIs to purchase equity, equity-linked instruments or debt instruments issued by an Indian start-up, irrespective of the sector in which it is engaged, subject to compliance with the sector-specific conditions (as applicable).

Sector-Focused Funds

SEBI has notified the Securities and Exchange Board of India Real Estate Investment Trusts Regulations 2014^[15] (the REIT Regulations) to regulate any investments in the Real Estate sector and the SEBI Infrastructure Investment Trusts Regulations 2014^[16] (the Infrastructure Regulations) for the infrastructure sector. An infrastructure investment trust (InvIT) and a REIT must be registered with SEBI to conduct their business.

Real Estate Investment Trust

A REIT is a trust formed under the Indian Trust Act 1882 (the Trust Act)^[17] and registered under the Registration Act 1908^[18] with the primary objective of undertaking the business of real estate investment in accordance with the REIT Regulations. The REIT is created by the sponsor of the trust, the trustee oversees the entire REIT and ensures all rules are complied with while the manager manages the investment decisions, and the beneficiaries are the unitholders of the REIT. They can invest only in SPVs or properties or transfer development rights in India or mortgage-backed securities. The minimum subscription for any publicly listed REIT is 50,000 rupees and the minimum trading lot is 100,000 rupees.

Infrastructure Investment Trust

Similarly, an InvIT is a trust formed under the Trust Act and registered under the Registration Act. An InvIT is created by the sponsor of the trust, the ownership of the property vests in the trustee and the beneficiaries are the unitholders of the InvIT. A sponsor creates a trust and a trustee is appointed to hold the assets of the trust in benefit of the unitholders. The investment manager then makes the decisions for the InvT and is responsible for the management of any projects undertaken. An InvIT is required to hold not less than 51 percent of the equity share capital or interest in the project SPVs. The minimum subscription from any investor in any publicly issued InvIT is 100,000 rupees.

The Infrastructure Regulations and the REIT Regulations regulate the investment and borrowing powers, along with any other requirements. They also provide for the rights and obligations of different entities involved and the valuation of assets and the distribution policy of REITs and InvITs. However, Infrastructure Regulations exclude projects that generate revenue or profit from rental or leasehold income. The Companies (Acceptance of Deposits) Rules 2014^[19] (the Deposit Rules) have been amended to exclude amounts received by a company from a REIT from the purview of ‘deposit’ under Rule 2(1) (c) (xviii) of the Deposit Rules. This is in accordance with the earlier amendments, which also excluded amounts received from AIFs, domestic VCFs, InvITs and mutual funds registered with SEBI.

Banks are allowed to participate in REITs and InvITs with a ceiling of 20 percent of their net owned funds for direct investments subject to a few conditions:

• the banks must have put in place a board-approved policy on exposure to REITs or InvITs specifying the internal limit on such investments within the overall exposure limits in respect of the real estate sector and infrastructure sector;
• not more than 10 percent of the unit capital of a REIT or InvIT can be invested by the banks;
• and the banks must adhere to the prudential guidelines of the RBI, as applicable.

Presently, there are two public InvITs, three privately placed InvITs and one listed REIT. As per SEBI, investors infused 6.7 billion rupees in REITs and 113.47 billion rupees in InvITs aggregating to 120 billion rupees in 2019.^[20]

Impact of Covid-19 on PE Investments

The COVID-19 pandemic has spread quickly and widely, and the rising number of cases is impacting businesses globally. This global humanitarian crisis has not only affected small and medium enterprises, but also the start-ups have faced an umpteen number of challenges. In the last few months, there has been an evident dip in investments and start-ups are struggling to sustain their businesses in terms of getting funds, cash liquidity, etc. The economic and political uncertainties have put a brake on funding for Indian start-ups. Since March 2020, when the disease was declared a pandemic, the private equity and venture capital investments in India have reduced significantly.

Owing to the nationwide lockdown and the restrictions, PE and VC investments are projected to fall by 45-60 percent in 2020.^[21] The fact that due diligence and negotiating process in India often takes significantly more time cannot be ignored. The travel restrictions and the inability to have in-person meetings have led to sluggish progress in the ongoing deals. With the pandemic disrupting businesses, supply chains, as well as demand growth, the revenue is slowly starting to drop. Although the PE and VC activity might grow in terms of volume, it is possible that the deal sizes take much more time to grow at ‘pre-COVID level.’ As the lockdown eases, certain industries such as Healthcare, Pharmaceuticals, Technology and E-commerce would continue to remain robust in this environment. These industries may offer opportunities for Investment firms for long-term growth.

Conclusion

As the Indian economy continues to grow its funding requirements for core and key sectors shall continue to rise and thus structural reforms to build the bridge between capital providers and capital seekers is a step in the right direction. Therefore, any regulations governing private equity investments in India will be of great importance to the economic growth of the nation. In 2020, PE investments are expected to grow by 15 to 20 percent as a result of India’s growth potential owing to government initiatives, a conducive regulatory framework, enhancement in ease of doing business and encouragement to new avenues of investment (such as REITs and InvITs).^[22] Accordingly, SEBI strives to deliver on its commitment to support the AIF industry in its growth. In the last few years, SEBI has been actively making REITs in India legally and commercially viable. It has driven the process in terms of smoothening the edges around the applicable regulatory framework, and a consequence of that has been enabling amendments to a host of regulations across various regulators.

Apart from private equity regulations, the other recent legal, tax and regulatory reforms also provide a stimulus to the AIF industry. These funds are thus well poised to play a vital role in channelizing domestic and offshore savings towards creation of economic value generating assets, businesses and industries. A well-oiled financial services and asset management industry shall allow India to set out on a path of sustainable long-term growth and improve its competitiveness in attracting foreign capital and other global investors.

Further, Indian courts have also played their part in growing foreign investor confidence in the Indian jurisdiction through their judgments in NTT DoCoMo Inc. v. Tata Sons Ltd^[23] and Cruz City v. Unitech^[24] , where they have shown a pro-enforcement stance on foreign arbitral awards and secured the exit rights of foreign investors in Indian companies. This is an important consideration for many companies looking to invest in India. In the dispute between Tata Sons and Tata Teleservices and NTT DoCoMo Inc., the court ruled that the Reserve Bank of India did not have standing to prevent enforcement of a foreign award between two private parties on grounds of Indian public policy.  And in the Cruz City case the court dismissed a challenge to enforcement by an award debtor arguing that a foreign award was contrary to Indian foreign exchange regulations. This outlook from the court allows PE investors to expect more portable and cleaner getaways in the future.

In conclusion, several reforms have contributed to making India a favourable investment destination. These reforms have attracted further investment by PE investors and have also facilitated their exits.

^[1] Dr. Tom McKaskill, ‘An Introduction to Angel Investing: A guide to investing in early stage entrepreneurial ventures’ (2009) Breakthrough Publications <https://www.angelcapitalassociation.org/data/Documents/Resources/McKaskill-_Intro_to_Angel_Investing.pdf> accessed on 07 October 2020

^[2] Private Equity International <https://www.privateequityinternational.com/database/#/pei-300> accessed on 05 October 2020

^[3] S. Povaly Private Equity Exits (first published 2007, Springer)

^[4] SEBI (Alternative Investment Funds) Regulations 2012, s 2(1)(b)

^[5] SEBI (Alternative Investment Funds) Regulations 2012, s 2(1)(b)

^[6] SSEBI (Alternative Investment Funds) Regulations 2012, s3(4)(a)

^[7] SEBI (Alternative Investment Funds) Regulations 2012, s 3(4)(c)

^[8] SEBI (Alternative Investment Funds) Regulations 2012, s 3(4)(b)

^[9] SEBI (Alternative Investment Funds) Regulations 2012, s 9

^[10] Guidelines on disclosures, reporting and clarifications under AIF Regulations (SEBI circular no. CIR/IMD/DF/14/2014)

^[11] Reserve Bank of India, Money Transfer Service Scheme – Delegation of work to Regional Offices-Submission of Statements / Returns (RBI Circulars No. 49, 2007)

Reserve Bank of India, Compilation of R-Returns: Reporting under FETERS (RBI Circulars No. 50, 2007); Guidelines on overseas investments and other issues/clarifications for AIFs/VCFs

^[12] Reserve Bank of India, Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (Notification No. FEMA. 395/2019-RB, 2019)

^[13] Reserve Bank of India, Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 (Amended upto June 15, 2020) (Notification No. FEMA 20(R)/ 2017-RB, 2017)

^[14] SEBI (Foreign Venture Capital Investors) Regulations 2000 [last amended on March 6, 2017]

^[15] SEBI (Real Estate Investment Trusts) Regulations, 2014 (last amended on December 15, 2017)

^[16] SEBI (Infrastructure Investment Trusts) Regulations, 2014 [Last amended on March 6, 2017]

^[17] Indian Trust Act 1882

^[18] The Registration Act 1908

^[19] The Companies (Acceptance of Deposits) Rules 2014

^[20] RK Jain, ‘Evolution of Global Private Equity Market: Lessons, Implications and Prospects for India’ <https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2109> accessed 05 October 2020

^[21] Amit Khandelwal, ‘Covide-19: projected impact on Indian PE/VC’ EY <https://assets.ey.com/content/dam/ey-sites/ey-com/en_in/topics/private-equity/pe-vc/covid-19-projected-impact-on-indian-pevc.pdf> accessed 05 October 2020

^[22] Raghubir Menon, ‘The Private Equity Law Review’ 9 The Law Reviews <https://thelawreviews.co.uk/edition/the-private-equity-review-edition-9/1224926/india> accessed 05 October 2020

^[23] Ntt Docomo Inc v Tata Sons Limited [2017] OMP (EFA) (Comm.) 7 (Del HC)

^[24] Cruz City v unitech [2017] EX.P.132 EA(OS) NO. 670/2016 ( Del HC )