The Indian economy, since the 1991 reforms has been on a growth trajectory and several advanced steps have been taken in all fields such as Banking, Legal Policy, Finance, Investment Policies, etc. Capital plays the most significant role in the survival of a company. The sources of such capital are manifold, depending on the short-term as well as long-term needs. One of the most preferred mediums for capital growth, usually for private unlisted companies are Private Equity funds. The Private Equity industry in India has developed over two decades. Starting from a nascent stage, the industry has evolved over time to a level that attracts global investors. In simple words, private equity refers to an alternative investment of capital into a business. It is a form of financing, whereby the capital is invested by private investors, such as funds and investors who directly invest and engage in public companies.
During the quarter ended March 2019, Private Equity and Venture Capital firms invested $ 10.1 billion which is up 26% in comparison to the same quarter last year in 2018 when PE and VC invested $8 billion.
In this article, there are provided a historical and regulatory framework in India on private equity. In addition to that, it also delves on key steps for investment transaction by PE players, due diligence as well as exit strategies of PE players. It also concisely encapsulates and put a perspective on the impact on PE investment due to corona pandemic as well as briefly cast light on distinction on often used but confusing and subtle terms of Private Equity and Venture Capital.
Development of Private Equity
The advent of Private Equity has come to mainstream spotlight only in the last three decades. However, the strategies used in the industry have existed for a long period of time. This history goes back to the year 1901. JP Morgan is said to have conducted the first purchase of Carnegie Steel Co., then the largest producers of steel, for $480 million. He merged the acquired entity with other steel companies to create the world’s biggest company – United States Steel with a market capitalization of $1.4 billion.
After World War II and until the 1970s, private equity firms continued to be a secondary source of funding. Nevertheless, after this period the venture capitalists started bankrolling. After the 1970s, private equity became a popular avenue for companies to raise funds. Today, several technology giants such as Apple got funds from Silicon Valley’s emerging financial ecosystem. The scenario in India started to change in the late 1990s with the IT boom. Venture Capitalists started making huge investments in start-ups and early-stage companies. After several downturns, Private Equity investors started investing in the Indian market again, spreading their investments across various sectors to mitigate risks. In recent years, private equity firms are booming and there has been a resurrection of the industry. The stock markets are booming and the funds are spread across sectors such as life sciences, real estate, as well as infrastructure. Firms such as Blackstone, Goldman Sachs and the Carlyle Group have widespread operations in India, and the industry has witnessed tremendous growth.
Regulatory Framework in India
Typically, private equity funds in India are set up as trusts and registered as alternative investment funds under the Securities and Exchange Board of India (“SEBI”) (Alternative Investment Funds) Regulations, 2012. Apart from trusts, private equity funds can be set up as companies and limited liability partnership (LLP).
1) SEBI (Alternative Investment Funds) Regulations, 2012
Intending to extend principles to unregulated funds and to increase market accountability and stability, SEBI notified the Alternative Investment Funds Regulations, 2012 (hereinafter referred to as ‘AIF’ Regulations). The regulations notified on May 21, 2012 served as a replacement and repealed the SEBI (Venture Capital Funds) Regulations, 1996. AIF is spread across 3 categories. AIFs which do not fall under Category I and III have been categorized under Category II.
As per the regulations, private equity funds are registered as Category II. These regulations were prepared to create a uniform structure for governing private pool of funds and investment vehicles to better channelize funds. Private Equity Fund has been defined under Regulation 2 (1) (r) of AIF Regulations 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”.
Recently, SEBI issued a circular which introduced several significant changes to the existing legal framework. To enhance disclosure requirements, SEBI has prescribed mandatory Performance Benchmarking, Standardization of Private Placement Memorandums (PPM) which is a primary document to disclose to potential investors all necessary information, and Annual Audits for AIFs. These changes have come into effect from March 1, 2020.
2) The Companies Act, 2013
The Companies Act was a much-needed overhaul for the governance of companies in India. Unlike the 1956 Act, the Companies Act 2013 placed heavy compliance and regulatory burden on private companies. Since the private companies are not permitted to raise capital by offering securities to the public, they raise capital through the process of ‘private placement’, in which securities are issued to a select number of private persons. Companies have to comply with provisions of Section 42 which governs the process of ‘Private Placement.’ The Section states that an offer or invitation cannot be made to more than 200 persons, excluding Qualified Institutional Buyers and securities offered under the Employee Stock Option Plan. However, these extensive regulations in connection with private equity funds are misplaced. Regulation of investments being made through private equity funds does not require heavy compliances as the securities are not being offered to the public.
Key steps in a Private Equity transaction
In India, private equity investments often take place in closely held unlisted companies. Investments in listed entities are not preferred for several reasons such as lack of quality assets, strict delisting regulations, etc. Private Equity Transactions comprise of early-stage investments, including seed capital, angel investments, venture capital, growth capital, and late-stage investments, including private investment in public equity, buyouts, and turnaround capital. Earlier, early-stage investments fell under venture capital investments; however, the trend has changed for the past few years due to the competitive deal sizes and valuations. Even though the transactions usually take place in a similar manner, the details can vary depending upon the investment firm and their process. The steps involved in a typical private equity transaction are as follows:
a) Teaser sent by Investment Bankers
An investment teaser is a document that briefly introduces the investment opportunity to the strategic partner or investor. Teasers are usually prepared without disclosing the name of the seller. Preparation and delivery of a teaser are one of the first steps in a private equity transaction.
b) Non-Disclosure Agreement (NDA)
Once the teaser is seen by the interested parties, it is necessary to sign an NDA. This prevents the unlawful use of any confidential information from being used to poach employees, solicit clients, etc.
c) Confidential Information Memorandum (CIM)
After an NDA has been signed, the bankers share the Confidential Information Memorandum with the potential acquirer. The CIM contains all the details about the company such as the investment thesis, overview of the company, employee profile, revenue profile, and financials. The idea is to put forward every relevant information before the acquirer so that they can decide whether to acquire the company or not.
d) Communication between the Seller and Acquirer
While looking at the CIM, it is possible that the acquirer would want to know several details about the company such as the credibility of the financials, customer relations, etc. For such purposes, the acquirer then gets in contact with the management team of the seller to ensure credibility and to find out the broad objectives of the seller company.
Based on the financial and projections, the acquirer company performs a valuation of the seller company. This step is critical as the PE does valuation based on such projections and financials.
f) Expression of Interest
The Expression of Interest if the formal offer that the Private Equity firm/Potential Buyer makes to the seller. As the name suggests, the acquirer expresses its interest to acquire the company for a certain valuation. However, such an offer is non-binding in nature.
g) Granting Access to Data Room
Once the bid is accepted by the bankers, the potential buyers are given access to the data room. Nowadays, the data rooms are available virtually. The idea behind granting such access is to make sure that the acquirer performs proper due diligence and verifies facts and data.
h) Management meetings
The next step in a private equity transaction is the in-person meeting of the senior management. The management of both, the seller and acquirer companies meet to discuss the collaboration and the advantages that it may bring for both the parties.
i) Letter of Intent
Before the Share Purchase Agreement is sent to the seller, the acquirer shares a letter of intent with the seller. This letter of intent highlights the broad terms of the acquisition to appraise the seller of the representations and warranties.
j) Share Purchase Agreement /Asset Purchase Agreement
A Share Purchase or Asset Purchase Agreement is a document that contains detailed terms and conditions of the agreement entered into by the companies for a private equity transaction, joint venture, etc. This agreement is binding in nature. Investment bankers play a huge role to ensure that the parties reach mutual accord and close the deal.
Any transaction such as private equity, venture capital, or merger and acquisitions has to be executed and planned with utmost care. Therefore, before a deal closes, the buyer or the investor has to carry out a thorough research about the target company. Generally, due diligence refers to the investigation or research which an Acquirer typically conducts. The process entails a broad spectrum of issues like accounting, tax, commercial as well as legal standpoints. There exists no straitjacket formula to follow during the process of due diligence and the process majorly depends upon the nature of the transaction.
From a buyer’s perspective, due diligence exercise is certainly important. This is because due diligence allows the buyer to rectify several claims and reduces risk while acquiring a company. However, due diligence not only benefits the buyer but also assists the seller in several ways. The rigorous financial investigation and examination may, sometimes, reveal the fair market value of the seller’s company. Thus, it is not uncommon for sellers to conduct due diligence of their own companies. Due diligence is an important exercise in order to identify potential risks and defects in the transaction, thus, saving a buyer from future jeopardies. Key steps involved in due diligence are briefly stated below:
I. Overview of Target Company
The due diligence process starts with the acquirer (“Buyer”) ascertaining the reasons for which the seller sells the company. Additionally, the acquirer aims to find out about previous attempts of selling the company, long-term goals, etc.
II. Financial Matters
Second step is a vital one. The buyer will be concerned about the financials of the company they are acquiring. This includes annual and quarterly financial statements, audit reports, etc. This step also includes inquiring into the assets and liabilities that the company might have, to assess the future performance of their projects.
III. Corporate Matters
This step includes inquiry and wary review of the documents and general corporate matters of the target company. Review of charter documents, list of subsidiaries, current officers and directors, stockholder agreements, and other related matters fall under this step.
IV. Customer Relationship/Sales
The requisite issues under this step include understanding the customer base and relationship. Apart from that, facilitating an understanding of several matters such as customer concentration risks, top customers and the revenue generated, sales policies etc. is important.
V. Contractual Matters
Probably one of the most time-consuming steps is assessing the contractual obligations and matters. This includes a review of material contracts and commitments, customer/supplier contracts, guarantees, loans, settlement agreements and other related issues.
VI. Employee-Management Issues
Another important aspect is to assess the employee-employer relationship of the target company. The buyer reviews the management hierarchy, disputes between the employee and employer, pending labor disputes, employment manuals and policies, etc.
This step involves an overview of the pending cases against the Target Company. Additionally, the buyer reviews the filed or pending cases, settled cases and terms of the settlement, arbitration matters, etc.
VIII. Tax Issues
An understanding of the tax compliances and any contingent issues is critical, depending upon the nature and past operations of the company.
IX. Intellectual Property
This includes enquiring into the patents owned by a company, the technology they own, registered trademarks, service marks, copyrights, etc. Any IP litigation is also assessed during this stage.
X. Related Party Transactions
The buyer will also need an understanding of the related party transactions such as agreements or arrangements between the target company and its current or former officer, director, stockholder, or employee.
The core objective of a private equity investment is to realize the return on the investments they have made in the company. Private equity funds usually have a fixed life span of around ten years. In simple words, private equity investors buy to sell. In fact, an investor typically strategizes the exit momentum right at the time of acquisition. A private equity fund acquires a company, increases its value by controlling operations, and subsequently, sells off the company. Thus, an exit strategy is basically the investor’s plan to sell their ownership in a company, after a certain period of time. While the exit strategies keep changing as per the market trends, some of the most common strategies include:
i. Initial Public Offering (IPO)
This is one of the most popular and common exit strategies used by private equity funds. IPO, also known as “floatation” or “listing” is a strategy by which the company’s shares get listed on the stock exchange. Through this, the shares are put up for the public to invest in. However, the volatility in the stock market affects this strategy, since the exit will only be complete when the shares are sold.
ii. Trade Sale
Using this strategy, the private equity investor sells all of its shares to a third-party purchaser. The sale is usually done to a company operating in the same market. Unlike IPO, this strategy offers an added advantage as the revenue is realized almost immediately.
iii. Secondary Buy-out
This exit tactic shortens the life-span of the private equity investment than what it originally was. This plan of exit involves the sale of private equity investment to another private equity fund, which ends the investment of the original buyer. This allows the private equity investor to have a clean exit from the company, for reasons such as the company might not be interested in the investment anymore, etc.
iv. Dual-track process
This plan assists the Private Equity firm to look for a suitable exit plan while testing its investment in the public market. The “dual-track process” involves a company filing their prospectus for IPO, while also looking for a way to exit via trade deal.
v. Leveraged Recapitalization
A leveraged recapitalization is a plan in which a company changes its capitalization structure by replacing the majority of its equity by debt. It is a partial exit strategy that allows the company to obtain additional cash, without selling the company. Usually done to pay large dividends or for buyback of shares of the company, this form of strategy can also be used to prevent hostile takeovers. However, this form of strategy can be risky as it increases the risk of bankruptcy and a lack of liquidity to operate the company.
Financial Epidemic: Private Equity and Covid-19
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 who 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. 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.
Private Equity and Venture Capital – A Comparative analysis
The ambiguity between private equity and venture capital funding has existed for a long time. 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.
Conclusion: What lies ahead?
Undoubtedly, private equity and venture capital funds play an important role in promoting entrepreneurship and economic growth. In exchange for equity, these investors take up positions and shares in the companies they invest in. However, in the Indian context, these funds usually consider taking up a minority stake due to the concentration of shareholding in the hands of the founder. Regardless of the commitment towards liberalizing the economy and pushing the ‘ease of business’ agenda, India has been subjected to a lot of criticism over the past few years due to its stringent laws and regulations. Today, a company has to face several legal hurdles and adapt to the ever-changing regulations. The fact remains that India has lost its attractiveness when it comes to PE investments. Amid the economic scenario and lackluster legal regime, PE funds are finding it difficult to raise funds from foreign investors. Nevertheless, the abundance of talent in India offers a great opportunity across several sectors. The highly regulated environment, however, is not necessarily a problem. As India clears out the economic hurdles, it will certainly become a hotspot for foreign investments.
This article has been written and submitted by Mr. Saksham Grover during his course of internship at B&B Associates LLP. Mr. Saksham is a fifth-year law student at the Delhi Metropolitan Education, Guru Gobind Singh Indraprastha University, Noida.
Moderated by Shubham Khunteta (Associate).