In the past 5-10 years, Indian entrepreneurs have become accustomed to utilising venture capital and private equity investments to fuel the growth of their companies. The phase between 2006 and 2008 (up until the “crash”) saw a large number of investments that were fuelled by the easy availability of capital for PE investors and the “India story”. A number of these investments are now reaching maturity and 2013 and 2014 are poised to be the “exit years”.
Unlike the pre-“crash" era, today’s market is a more cautious place. There is a sharp contrast between the exit scenarios anticipated by PE investors while they were investing and the ground realities of the present market. Apart from the changing market dynamics, there are legal issues and uncertainties about exits that have been permitted to perpetuate, which will play a critical role while these PE investors formulate their exit strategies.
The Heyday Exit Rights
When investments were made by PE investors in 2006-08 period, the most likely and favourable exit option contemplated was an initial public offering. Often, piggyback registration rights to foreign stock markets were also negotiated, given the popularity of depository receipts being listed on foreign stock markets in the period preceding 2006. The next contemplated exit was usually the sale of the investee company to a strategic investor via an M&A transaction, once again seen as a likely and favourable exit. Following these, the PE investor generally sought a right to freely sell its stake in the investee company and sought the co-operation of the promoters of the investee company and the investee company itself for conducting such a sale. As a last resort, some PE investors obtained put options and buy-back rights coupled with a right to drag-along to ensure their exit, though these were often strongly resisted by promoters and investee companies. The PE investors did not always end up with the best deal as in that time there was tremendous competition from other funds and promoters would often see multiple term sheets before proceeding with any particular investor. This resulted in some PE investors getting their fingers burnt badly. However, the overall exit waterfall discussed above was by and large true, for a majority of PE investors.
The Winds of Change
From market to stake sales: Since 2008, the stock market lost favour as an exit route for PE investors, owing largely to the state of the market itself and a general reluctance towards IPOs after some spectacular post IPO crashes. As a result, most PE investor exits these days involve private stock sales to financial or strategic investors, perhaps with a combination of promoter put options and investee company buybacks. The relative threat of a put, buyback or drag-along exercise results in PE investors being able to get investee companies co-operate and assist in their exit sales.
Negotiating indemnities: The differences between the projected scenarios and the ground realities of today’s market show up in the nuances of an exit sale. Such sales are often made to offshore investors, including funds. In a transaction involving stake sale by an existing PE investor to an incoming investor, the promoter or the investee company often does not receive any new money. In such cases negotiating indemnities and operational warranties to the new investor from the promoters and the investee company have become tricky issues and often depend on the effectiveness of the last resort exit rights that the existing PE investor has.
Another interesting development has been in the area of warranties and indemnities that the exiting PE investor itself provides to the new investor. While standard PE documentation usually excludes the PE investor from any onus of providing representations, warranties or indemnities to the incoming new investor in an exit sale (and the existing PE investors are often restricted from doing so by their fund documentation), post the Vodafone case and the proposed introduction of the general anti-avoidance rules, many PE investors have provided tax indemnities to buyers during their exit. Corresponding insurance policies are also becoming increasingly common. Certain PE investors have had substantial operational involvement in investee companies and in these situations, full operational indemnities may be sought by the incoming investor, though not always provided and usually resisted.
Is put an option: The last resort exit options (put options and drag along rights) also pose a number of legal and regulatory hurdles. Put options with internal rate of return guarantees (once a favourite of PE investors) have been questioned by RBI (as being quasi-debt and thereby attracting the External Commercial Borrowing Guidelines) and there is a lack of clarity as to whether they will be enforceable. At present, a counter threat exists from promoters who had signed investment agreements contemplating put options with internal rate of return guarantees, who may approach RBI to get a put option nullified. As a result, such put options are rarely exercised and if at all they are, it is usually due to a good faith relationship with the promoters of the investee company. Further, there is a lack of clarity in relation to buyback of convertible instruments as they may be seen as a mechanism to seek redemption while circumventing RBI’s External Commercial Borrowing guidelines.
Few other developments: The incoming investors, especially strategic investors, may seek milestone based escrows to secure the valuation at which they are buying the stake in the investee company. Given the relatively short time left in fund lives from the time of exit, these are usually being resisted by exiting PE investors.
Incoming investors are not always spared either, there are times when incoming investors do not receive indemnities, especially when the exiting PE investor is satisfied with the value accruing to it and the investee company and its promoters are unwilling to provide the indemnities. Furthermore, disclosures in relation to representations were heavily negotiated in the past, nowadays vendor due diligence reports and even entire data rooms (though rare) are being accepted by some incoming investors as disclosures.
Incoming investors commonly use a carrot and stick mechanism to get the best deal, usually by making on-going equity commitments post the conclusion of their purchase in order to get the best deal out of the investee company.
Due to the expense involved in completing a stake sale, both sides are seeking break fees, something which may become common practice in the future. As payments such as break fees and indemnities are not strictly contemplated under the existing foreign exchange management regime in India, there is a chance that such payments may be opened up and questioned by RBI.
The RBI has also recently indicated that sales by foreign venture capital investors to non-resident buyers would require RBI’s permission. It is clear that due to the piecemeal nature in which India’s foreign investment regime has evolved as well as the ambiguous application of the law by the relevant institutions, foreign investors are faced with a level of uncertainty which doesn’t bode well with the market, especially in its current state. These uncertainties have been around for some time now, in the past few months a new FDI Policy has been announced, a new RBI Master Circular on Foreign Investment has been issued and amendments have been made to the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (which cover non-resident’s transactions in shares). However, none of these have provided clarity in relation to the long pending issues described above. It would be immensely helpful if clarity on these issues could be provided by the regulatory authorities so that PE investors can move towards their exit with more confidence.
It can be clearly seen that the realities of PE investor exits in India have changed over time, so has the attitude of investors which was prevalent at the time of their investment. The importance of IPOs as exits have diminished in recent times and exit rights relating to stake sales, put and buyback options and drag-along rights are now hotly negotiated. Given the impending conclusion of the first major PE investment cycle in India, it is likely that a certain level of maturity and experience will show up in future investments.
