Put option exit pricing may hurt PE investors

Private equity firms won't get to use internal rate of return model, as the central bank is against fixed returns

The Reserve Bank of India (RBI) allowing the use of put options in investment agreements has brought needed clarity but it has come with strict restrictions. These could impact investors looking for a minimum rate of return, experts say.

The central bank has, by an amendment to the foreign exchange management (FEMA) regulations, given a go-ahead to foreign investors for using popular preferential clauses such as put options with a condition that there will be no assured exit price at the time of making an investment.

The move, experts say, will put foreign private equity (PE) investors, especially those who opt for a guaranteed internal rate of return (IRR) model, in a disadvantageous situation compared to their Indian counterparts. A put option gives an investor the right to sell a security at a future date in any merger and acquisition (M&A) transaction. To prevent companies from promising assured returns to investors, through the use of such clauses, the RBI prescribed a formula to arrive at an exit price.

EXIT OPTIONS

• RBI has permitted use of put options by foreign investors
• Options should be without right to exit at an assured price
• Minimum lock-in period for investment should be one year
• Exit price to be arrived at using a formula
• Norms could hit PEs eyeing fixed-return equity investments

For listed companies, the exit price will be determined by the secondary market price on the stock exchange. For an unlisted company, it will be based on return on equity (RoE) according to a company's latest audited balance sheet. Meanwhile, in case of preference shares or debentures, there will be slightly more flexibility as the price can be determined by "internationally accepted pricing methods".

“RBI has imposed certain conditions to ensure that only genuine options in securities are valid,” says Lalit Kumar, partner, J Sagar Associates. “The exit pricing formula means there cannot be guaranteed returns. For instance, a non-resident PE investor cannot get a guaranteed IRR by the Indian investee company or the Indian promoter at a time when such PE investor makes the investment.”

Most private equity investors follow a guaranteed IRR model while investing in companies. Nishchal Joshipura, partner, M&A and private equity, Nishith Desai Associates, believes debentures might get preference over equity shares in investment agreements. “Capping the put option price for equity shares at return on equity may not reflect the fair value of the portfolio company at the time of exit,” he says. The exit pricing formula won’t hurt joint venture partners, as they typically don’t enter a transaction with a fixed return in mind, say experts.

“The recent notification by the RBI has cleared the air over enforceability with respect to shares or debentures containing options with a non-resident investor,” says Kumar.

The enforceability of these instruments by foreign investors was in question due to a lack of clarity from the RBI even though securities market regulator Sebi had permitted it in October last year.

The use of put options, according to earlier Fema regulations, by non-residents was treated as a debt instrument, instead of equity, and hence required compliance with the external commercial borrowing requirements.