Challenges faced in leverage buyout model by Private Equity firms in India

Private Equity investments have played a major role in corporate growth on a global level. Private Equity firms (PE firms) have usually invested in companies through the financial strategy of Leverage Buyout. However, these firms have to adopt a hybridised and customised model to deal with the ubiquitous role of complex investment regulations, extant laws and promoter-based nature of private companies. PE firms invest in India through a minority stake with contractual rights in corporate governance and investment protection.

For institutional investors, Leverage Buyout (LBO) is a strategy to acquire equity in a target company for investment. The word ‘Leverage’ suggests significant debt taken by the investors from the financial institutions against the assets of the target company.[1] The word ‘Buyout’ suggests the gaining of controlling majority of the target company to control the cash flow to service the debt and performance of the company. This is necessary for the exit of the investor with a profitable internal rate of return. According to this financial strategy, a minimum percentage of the investment amount is generated through the PE firm and the rest is generated through financial institutions using the target’s assets as leverage. Usually, the target companies are in the mature business of scale and thereby they generate operating cash flow to support the leverage.[2] After LBO, the target company usually becomes a private company to provide investor control over the company. Buyouts are one of the most popular categories of private equity investments.

PE firms have played an important role as investors in Western markets. In such economics, PE firms usually invest in the companies which have a mature market to grown and have strong cash flows[3] with the ultimate aim to make the company public through an Initial Public Offering (IPO) or selling it to a strategic buyer. However, in India, this financial strategy is restricted through legal regulations and the cultural context affecting the Indian private companies.

• Restrictions under FII

In India, Private Equity investments happen through the Foreign Institutional Investor (FII) route. This allows easy access to buying and selling of securities on the Indian stock market. A single FII is prohibited from investing more than 10% of the paid-up capital and aggregate should not be more than 24% of the equity capital of an Indian company. The company can increase the limit by a board approval and a special resolution at a general meeting. If the limit is not prescribed by the PE firm to then such transaction requires the prior approval of the Foreign Investment Promotional Board (“FIPB”)[4]. This provides a restriction for a PE firm to acquire even twenty-five per cent of share capital without the permission of the Regulating authorities.

• Restrictions under the Companies Act, 2013 and SEBI regulations

The Companies Act, 2013 provides for deterrence for LBO under section 67(2). The section prohibits public companies or a private company, which is a subsidiary of a public company for providing financial assistance for the reason of purchasing or subscribing to the shares of the company. This hinders the investor from leveraging the assets of the company for purchasing the equity in the target company. When a company receives LBO, it is converted into a private company and the investor gets the controlling stake in the company. The process in India for the conversion of a public company to a private company is cumbersome. The process of delisting is present under Securities and Exchange Board of India (Delisting of Equity Shares) Regulations, 2009. It provides for various thresholds, approvals, special resolution and public announcements. This discourages investing through LBO in a public company.

• Restrictions by Reserve Bank of India

If investment is made in a public unlisted company or a private company by FII or any foreign entity, then the investment is regulated by the Reserve Bank of India. The Reserve Bank of India released a Master Circular on Loan and Advances[5] on July 2015, which prohibited Indian financial institutions from granting loans for the purchase or subscription of shares in an Indian company and allows collateral for secured loans only for ‘working capital’ or ‘other productive purposes’. This restricts a PE firm from using assets of the target company as collateral to finance purchasing of the target’s shares. This is to ensure the safety of the domestic banks in regards to making advances against the shares.[6] The rationale behind such policy is for the investor or the promoter to provide for their contributions from their own resources.

• Investor as a promoter under the Companies Act, 2013 and SEBI regulations

As soon as the debt has been paid, the target private companies go public through an IPO or sale to a strategic investor. If a PE firm decides to exit the target private company after payment of LBO, the extant laws and complex restrictions stand in the way of the investor. As stated above, an investor has a controlling stake in the LBO. In this scenario, there is a chance for the investor to be categorised as a ‘promoter’. Under the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018,  a promoter is defined as a person “who has control over the affairs of the issuer, directly or indirectly whether as a shareholder, director or otherwise.”[7]  The definition further states that a venture capital fund, alternative investment fund or a foreign venture capital investor “shall not be deemed to be a promoter merely by virtue of holding twenty per cent or more of the equity share capital of the issuer is held by such person unless such person satisfy other requirements prescribed under such regulations”.[8] Therefore, a private equity investment fund, being an alternative investment fund, will not be deemed to be a promoter unless it exercises control in the target company. Control is described under section 2(27) of the Companies Act, 2013 as “the right to appoint the majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.” Therefore, as the investors under the strategy of LBO, exercise control and are majority shareholder, they will be classified as a promoter during the exit through an IPO. This will make the investors subject to the provisions providing for minimum contribution in IPO and promoter lock-in. Due to such provisions under Indian law, LBO in India is impossible. 

• Promoter-based private companies

In addition to this, many private companies in India are promoter-based or family-based. Majority of the equity and management is present with the promoter or the relatives of the promoter. The promoter/ relatives of the promoters may not want to divest their controlling stake in the company for additional capital.[9] This makes it difficult for PE firms to have control transactions. In absence of such control, it is difficult to leverage assets of the target company for the investment given the lack of control over cash flow to service the debt. This acts as a restriction for LBO.

• Hybridised and customised model

Therefore, PE firms, for their investments in Indian companies have to reply on a ‘hybridised and customised model’[10] to address the legal and cultural restrictions. The investors invest in a minority stake of the target company with rights in corporate governance and investment protection. Such rights can be for appointment of board representatives, veto rights, information rights, the right to participate in fundraising by the company, pre-emptive rights, exit rights, etc.

Even if the LBO model is impossible to carry out in India, the model of minority stake investment with contractual rights is a getaway for the PE firms to invest in Indian private companies. It does not allow for controlling majority in the private companies but does allowing for enough contractual rights to protect the investment and interest of the investors in the company.

[1] Choksi Narendra Challenges Faced in Executing Leveraged Buyouts in India the Evolution of the Growth Buyout (Glucksman Institute for Research in Securities Markets 2007) Pg 4

[2] Ibid.

[3] Neha Bhuwania Guide to Private Equity (Taxmann Publications 2014) Pg. 18

[4] Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2017 Regulation no. 10

[5] Advances against Shares, Units, Debentures and Public Sector Undertaking (PSU) Bonds Dir.BC.90/13.07.05/98 dt.28 August1998

[6] Choksi Supra note 1 pg 15

[7] Securities and Exchange Board of India (Issue Of Capital And Disclosure Requirements) Regulations 2018, regulation no.2(oo)

[8] Ibid. Regulation No. 2(e)

[9] Choksi Supra note 1 pg 11

[10] Afra Afsharipour Corporate Governance and the Indian Private Equity Model (2015) 1 (1) National Law School of India Review <https://www.jstor.org/stable/44283645>  accessed 23 October 2020 pg 48