Where PEs fear to tread

Cautious private equity investors evaluate whether to opt for a board seat, or be distant observers

The new company law could well trigger a change in boardroom equation between company promoters and private equity (PE) investors. According to provisions in the new Companies Act, the responsibility, risk and liability profile of PE directors in an investee company has gone up manifold.

This may make cautious investors choose an 'observer' status rather than a 'director' on company boards, say legal experts and PE firms. "PE investors may exercise their affirmative rights through shareholder action instead of seeking a board berth. This is more so when enforcement of affirmative rights may potentially be in conflict with a director's fiduciary duties," says S M Sundaram, partner and chief financial officer, Baring Equity Partners India. The trigger is a key change brought about by the new company law, wherein the PE nominees on the board of listed public companies and public unlisted companies will no longer qualify as independent directors. PE directors will have a non-executive position on the board though they will have to fulfil all the duties and responsibilities of a director as stated in section 166 of the Companies Act 2013. The duties of directors are towards a diverse band of "stakeholders" that include "the company, its employees, shareholders, community and for environment protection". There are severe penalties, in many cases even imprisonment, for non-compliance.

The challenge, says Lalit Kumar, partner, J Sagar Associates, a corporate law firm, for the nominee director is to strike the right balance between protecting all the diverse interests. For Pankaj Chadha, partner in a member firm of Ernst & Young Global, higher training is the answer. "Higher training is required for such directors to effectively discharge their duties," he explains.

Some also think that PE investors could play a more proactive role in audit committees of the company. Jamil Khatri, global head of accounting advisory services at KPMG, says, "This empowers the PE investor to play a greater role in the governance of the company."

Another issue galling many PE investors is the provision in the new Act for obtaining a valuation report from a Registered Valuer. "If a start-up company, or early stage company, or a company involved in development of intellectual property, is being funded by a venture capital (VC) or an angel investor, it would be difficult for any registered valuer to estimate the 'fair value' of shares of such a company," points out a PE player.

The change in the company law, prescribing a 12-month cooling period between two buybacks, makes this option unviable as an exit route, say many PE and VC investors. Buyback as an option for PE/VC investors had already become unattractive following an imposition of a 20 per cent withholding tax according to the Finance Act, 2013. "This may result in private companies finding it more difficult to access capital on affordable terms," says Baring Equity Partner's Sundaram.

In view of the strict restrictions on related party transactions in the new company law, however, PE investors may not able to vote on related party. This may increase their dependence on other shareholders who may or may not be aligned with their objective. There is, by and large, unanimity that PE funds will step up their due diligence before investing. "Once on the board, they have to be more alert and vocal on issues relating to corporate governance and internal controls. They also have to put their dissent - if any - on record," says Sanjeev Krishnan, leader, private equity and transaction services, PwC.

From the point of view of promoter companies looking to raise capital through the PE route, there are some restrictions. The new Companies Act prohibits the practice of creating treasury shares under a scheme. PE investors point out that holding treasury stock through funds - without allotting fresh shares - has historically enabled promoters to prevent hostile takeovers in certain situations. Termination of treasury shares will take away flexibility allowed to promoters. According to the new company law, preferential issue is now applicable to private limited companies. However, it has to be valued by a registered valuer. According to Rule 13 of Companies (Share Capital and Debentures) Rules, 2014, all preferential issues will also have to follow the provisions of private placement. This could be a challenge for companies looking to raise capital, says J Sagar Associates' Kumar.

Most PE/VC investors do not expect the new company law to help in curbing or resolving promoter-investor conflicts. Speedier implementation or enforcement of legislation would be more helpful than creation of new legislation, feel many in the investor community. It is early days yet for the new company law, and both, promoters and investors, are keeping a cagey watch on how the rule of law unfolds.

WHERE IT HURTS PE INVESTORS

PE nominees on the board of listed public company and public unlisted companies will not qualify as independent directors

Impact: Risk and liability profile of PE directors will change, penalties are more severe for directors

Minimum gap of one year between two buybacks of securities

Impact: Exits through buyback will have to be planned

Prohibition on forward dealings and insider trading by director and key managerial personnel

Impact: Applicability on unlisted public company and private company will pose challenges for investments

Insurance premium for directors and officers restricted to MD, whole-time director, manager, CEO, CFO and company secretary

Impact: Need to factor in risk of litigation through class action suits

Restriction on multi-layered structure could erode flexibility of PEs

Impact: New company law restricts the holding structure to two levels of holding companies, may impact investment through downstream subsidiaries

Preferential issue applicable to private limited companies

Impact: Preferential issue has to be valued by a registered valuer

WHAT WORKS FOR THEM

Articles of Association can contain "entrenchment provisions"

Impact: Shareholders can contractually agree on restriction on transfer of shares in a public company

No distinction between cumulative and non-cumulative preference shares

Impact: Preference shareholders will have voting rights on all matters on which equity shareholders can vote