i GENERAL OVERVIEW
Over the last decade, India has witnessed dramatic swings in the sentiments of the PE investors and the PE landscape in India has developed and matured significantly. 2017 reinforced the positive outlook that the investors have towards India as it witnessed an investment inflow of US$24.7 billion (surpassing 2015, which had an investment inflow of US$19.3 billion).2
The surge and momentum in PE activity in 2017 can be attributed to several factors. The reforms aiding tax and business over the past couple of years appear to have inspired confidence in the investors. While the economy is still settling down from the dual aftershocks of demonetisation and goods and services tax (GST) , the investor community is still looking at India positively and deriving strength from policy decision-making that is targeted at either cleaning up the economy or making it easier to do business. Dismantling of the Foreign Investment Promotion Board and the introduction of the Insolvency and the Bankruptcy Code (IBC) are also factors that caused a spur in PE activity.3 The IBC will offer significant opportunities to the PE investors to offer support to potential applicants under the IBC. The rise of India to 100th rank in World Bank’s annual ease of doing business rankings followed by the upgrade in India’s credit rating by Moody’s for the first time in 14 years also gave a boost to the Indian market.4
i 2017 v. 2016
2017 reported an aggregate fundraising of US$4.9 billion, which is a 15 per cent increase from the fundraising in 2016. While fundraising during the first and second quarter of 2017 reported a decline of 38 per cent5 and 24 per cent6 respectively in comparison to the respective quarters of 2016, the third quarter of 2017 reported US$2.2 billion worth of funds raised, which is the highest quarterly fund raised since 2010.7 The slowdown during the first couple of months of 2017 can be attributed to currency and political risk and uncertainty regarding the impact of demonetisation, which impacted the exit environment as well. Having said that, the local fund managers have had a positive outlook towards India due to a buoyant market with improving economic indicators and greater allocation of funds available for investment in India by the global funds.8 Various government initiatives (such as further liberalisation of the FDI policy, framework for ease of doing business in India, development of infrastructure, consolidation across key sectors, the ‘Stand-up India’ initiative for empowering deprived sections of the society and implementation of GST) also inspired confidence in the investors.9
Kedaara Capital Advisors Ltd raised the biggest sector-agnostic India-focused fund for US$795 million. The fund received contributions from Ontario Teachers Pension Plan (a Canadian pension fund) and other sovereign wealth funds, pension funds and endowments.10 The seventh fund of Chrys Capital, i.e., ChrysCapital VII, which crossed its US$600 million target was the second-largest fund raised in India during 2017. The fund has been raised with a view to invest in minority growth and select control opportunities in sectors such as business or financial services, healthcare, consumer and manufacturing sectors.11 Other significant fund raises of 2017 include HDFC’s US$550 million affordable housing fund, HDFC Capital Affordable Real Estate – 2, the US$350 million structured credit fund of Edelweiss Special Opportunities and the third India-focused fund US$350 million raised by SAIF to invest in technology start-ups and companies in the brick and mortar space.12
While there was some high-value fundraising in 2017, the decline in the number of the funds raised may be attributed to the surge in the number of companies going public in view of the bullish sentiments of the market.13 As a result, there was lesser demand for funds from PE investors. In fact, IPO was the most preferred route for PE exits also as it gives the PE investors the benefit to exit partially and retain part of their stake in the investee company to reap future benefits from the growth of the company. Given the positive market conditions and the favourable regulatory changes, 2017 witnessed a spurt of PE-backed IPO activity.14
ii Industry sector trends
Most of the funds raised this year were sector-agnostic funds. In continuation of the trends from 2016, healthcare, real estate and infrastructure sectors saw most of the fundraising activity. However, unlike last year, the IT and services and consumer products sector faced a slowdown in fundraising. Kedaara Capital Advisors Ltd’s US$795 million sector-agnostic India-focused fund was the largest fundraising in India in 2017.
iii Sector-agnostic funds
4 out of the top 6 funds raised in 2017 were sector-agnostic funds. These top four fund raises are the US$750 million Kedaara Capital Fund II raised by Kedara, Chrys Capital’s ChrysCapital VII (US$600 million), SAIF’s US$350 million fund and the US$350 million structured credit fund of Edelweiss Special Opportunities. The other sector-agnostic funds raised in 2017 include the US$250 million second sector-agnostic fund raised by CX Partners,15 the fourth fund of Madison India, which closed at US$230 million,16 the US$350 million new fund raised by Ascent Capital17 and the US$200 million fund announced by Lighthouse.18
iv Real estate
HDFC raised US$550 million for its second affordable housing fund, HDFC Capital Affordable Real Estate Fund – 2. This fund will be combined with the HDFC Capital Affordable Real Estate Fund – 1 raised by HDFC in 2016 to create a US$1 billion platform to invest in affordable housing projects.19 There is robust demand (but not enough supply) for affordable housing in India because of the continued economic growth and government initiatives to provide housing for all. Consequently, affordable and mid-income housing presents a lucrative opportunity for investors.20 Other investors who raised (or plan to raise) funds for investment in affordable housing include Kotak Realty Fund, which announced a US$100 million fund21 and IIFL Investment Managers, who propose to raise a US$500 million real estate credit fund.22 Other real estate funds announced or raised during 2017 include Indiabulls’ US$224 million real estate AIF, which focuses on approved and under-construction residential projects, the US$300 million commercial real estate fund announced by Ascendas-Singbridge Group23 and the US$20 million fund to be raised by Milestone Capital Advisors to invest in pre-leased assets.24
Constellaton Alpha Capital Corp, an India-focused healthcare special purpose acquisition firm, raised US$144 million through an IPO on NASDAQ.25 Tata Capital announced three funds in 2017, which include a US$120 million healthcare fund, Tata Capital Healthcare Fund II.26 IIM Ahmedabad’s Centre for Innovation Incubation and Entrepreneurship (CIIE) got apt apporval from the SEBI to raise Bharat Innovation Fund of US$149 million to invest in healthcare, sustainable energy and digital technology sector.27
vi Investments and exits
The value of PE investments (US$26.8 billion) increased by 65 per cent in 2017 while the volume of deals declined by 23 per cent, as compared to 2016.28 Investments came in from a more diverse set of investors in 2017, such as Warburg Pincus, GIC and CPPIB as well as domestic firms such as True North and Gaja Capital.29 The increase in deal value despite the decline in deal volume is due to some of the big-ticket deals. There were at least five PE investments of over US$1 billion in 2017 as compared to only one deal of over US$1 billion in 2016.30
The sectors that remained in focus were technology, financial services and infrastructure sectors. Softbank was one of the most active investors this year with three investments in the Indian e-commerce and fintech sector (US$2,500 million in Flipkart, US$1,400 million in Paytm and US$1,100 million in Ola along with Tencent). Other significant deals of the year include US$1,390 million investment by GIC in DLF Cyber City Developers Ltd, investment of US$956 million by KKR and CPPIB in Bharti Infratel Ltd and Bain Capital LLC’s US$795 million investment in Axis Bank Ltd.31
Another trend that picked up in 2017 was private investment in public equity (PIPE), accounting 12 per cent of the investment activity. The opportunity for private sector investors to invest in public equity has been accentuated by the current capital and asset quality challenges faced by public sector banks. The key PIPE deals in 2017 include investment of US$1.1 billion by Bain Capital in Axis Bank, investment of US$338 million in Kotak Mahindra Bank Ltd by Caisse de Depot Quebec and Canadian Pension Plan Investment Board and the US$260 million investment in RBL Bank Ltd by CDC Group and Multiples Alternate Asset Management Pvt Ltd.32
In terms of exits, 2017 surpassed the previous year by a remarkable margin in terms of both, volume and value. The value of exits in 2017 aggregated to US$13 billion (which is twice of US$6.7 billion, recorded in 2016). Qatar’s US$1.485 billion exit from Bharti Airtel was the biggest exit followed by Tiger Global’s exit from Flipkart at US$800 million and Apax’s exit from Global Logic at US$720 million. There has also been a sharp increase in open market exits (US$6.7 billion in comparison to US$1.7 billion in 2016) as more companies decided to go public to tap into the bullish sentiments of the market. IPO seems to be the preferred mode of exit for PE investors owing to the growing equity markets, better liquidity and positive investor sentiments. Fairfax’s exit at US$558 million from ICICI Lombard was the biggest IPO exit in 2017.33
vii Reception by LPs and fund managers
India has been ranked as the most attractive emerging market for investment by GPs for 2018 in a market survey conducted by the Emerging Markets Private Equity Association.34 In addition to the favourable regulatory and economic conditions cited above, the bullish approach of the global investors towards the Indian market could also be on account of low yields in their respective markets. The investors who propose to reduce their activity in emerging markets cite disappointing returns, currency volatility and political instability as the reasons.35 As far as India is concerned, historical performance and a weak exit environment have been generally cited as the deterrents for investment.
Given that exit is one of the top three concerns of LPs while investing in emerging markets, the exit environment in India needs to be tackled if it is to maintain its position as the most attractive emerging market for PE investments.36 As mentioned earlier, the market for IPO is booming with more companies choosing to go public to raise funds or provide an exit to their private equity investors. This increasing trend of IPO exits has contributed significantly in strengthening the PE landscape in India in 2017 and should give a boost to fundraising in India going forward.
ii LEGAL FRAMEWORK FOR FUNDRAISING
i Structure of offshore funds
Commercial and tax advantages form key considerations of investors while determining the structure of the fund vehicle. Offshore funds are mostly set up either as LLPs or a corporate entity in a tax-efficient jurisdiction outside India. Typically, the GPs, along with the investment manager who set up and operate the investment vehicle, are located outside India. The GP and the investment manager engage an adviser based in India (often an affiliate of the offshore fund), who looks for investment opportunities for the fund. However, the introduction of the General Anti-Avoidance Rules has provided the tax authorities the ammunition to disregard or re-characterise transactions on account of lack of commercial substance and deny treaty benefits. This has led to investors exploring unified structures where the LPs are pooling their investments in the same vehicle that directly makes the foreign portfolio investments. Increased investments by impact funding in India has also seen active involvement of development financial institutions. Internal policies of such global financial institutions are also impacting the way funds are being structured.
ii Preferred jurisdictions for offshore funds
Under the Indian tax regime, a non-resident investor is subject to tax in India if it receives or is deemed to receive income in India; or income accrues or arises or is deemed to accrue or arise in India. However, if the non-resident is based out of a jurisdiction that has entered into a double taxation avoidance treaty (DTA) with India, such taxation implications are nullified and the Indian income tax laws apply only to the extent they are more beneficial as compared to such tax treaties.
Understandably, the primary driver that determines the choice of jurisdiction for setting up India-focused funds is a domicile that has executed a DTA with India.
Currently, India has separate double taxation avoidance agreements with various countries such as Ireland, Mauritius, the Netherlands and Singapore.
Below is a brief overview of the various jurisdictions where India-focused funds are set up.
Over the years, Mauritius has been one of the most favoured destinations to set up India-focused funds and accounts for more than 30 per cent of the foreign investment into India. This is because India has a DTA with Mauritius, which provides various benefits like tax exemption on capital gains, robust dispute resolution network, and the right to repatriate capital and returns. However, the Indo-Mauritius DTA was amended in 10 May 2016 pursuant to a protocol signed between the respective governments (the Mauritius Protocol). Pursuant to the Mauritius Protocol, the capital gains tax exemption is being phased out and any capital gains arising from sale of shares (acquired after 1 April 2017 and transferred after 31 March 2019) will be taxable in India at full domestic rate of 15 to 20 per cent. Further, shares transferred before 31 March 2019, will be taxed at 50 per cent of the domestic tax rate of India subject to certain conditions. This phase out of the capital gains exemption is only applicable to sale of shares and not in respect of the sale of debentures.
Further, prior to the Mauritius Protocol, India did not have the right to tax any residuary income of a Mauritian tax resident arising in India. The Mauritius Protocol has now enabled India to tax ‘other income’ arising from a Mauritian tax resident in India. In addition, the Financial Services Commission, Mauritius has introduced domestic substance rules to determine if Mauritius-based entities are managed and controlled in Mauritius. India and Mauritius have also agreed to assist each other to collect revenue claims, upon a request from each other’s revenue authorities. All such measures, viewed cumulatively, signal India’s serious resolve to curb tax avoidance. From the investor or fund’s perspective, the phased withdrawal of capital gains tax exemption will give time to investors to reassess their investment structures in relation to India.
Further amends to the bilateral treaty between Mauritius and India will be necessary on account of Mauritius excluding the India-Mauritius DTAA from the scope of a multilateral deal brokered by the Organisation for Economic Cooperation and Development (OECD) in July 2017. Reports suggest that Mauritius is considering introducing changes in four areas of taxation: treaty abuse, dispute resolution, harmful tax practices and country-by-country reporting of operations by companies.
The benefit under the India-Singapore DTA is available only to entities that reside or are domiciled in Singapore. Further, the treaty benefits are linked to satisfaction of certain conditionalities, which is popularly known as the limitation of benefits clause. Unlike the treaty between India and Mauritius, the capital gains exemption under the India–Singapore DTA is linked to satisfaction of the limitation of benefits clause, which requires that the affairs of the Singapore entity should not be arranged with the primary purpose of availing of the capital gains exemption. In addition, the entity should not be a shell or conduit company.
The capital gains exemption under India-Singapore DTA was co-terminus with the capital gains exemption under the India-Mauritius DTA. Thus, taking its cue from the Mauritius Protocol, the respective governments of India and Singapore signed a protocol amending the India–Singapore DTA, introducing source-based taxation for capital gains arising upon transfer of shares (acquired on or after 1 April 2017) and enabling the application of domestic laws to curb tax avoidance or tax evasion. This language allows for the government of India to apply GAAR even to situations where a specific anti-avoidance provision exists in the DTA.
The Netherlands has been a popular jurisdiction primarily with portfolio investors. This is because the capital gains tax benefit is available to Dutch entities as long as they hold less than 10 per cent shares of an Indian company. In addition, for a Dutch entity to avail itself of relief under the India–Netherlands treaty, it needs to be liable to pay tax in the Netherlands. Hence, the treaty works well for investors based out of the Netherlands to achieve tax gains out of India.
While there were discussions around amendments being introduced to the treaty between Netherlands and India to align it with the changes made to the treaties with Singapore and Mauritius, a decision has been to leave the tax treaty unchanged.
Ireland has emerged as a preferred destination for debt or convertible debt instruments. While withholding reliefs under Indian law can be as high as 42 per cent for interest and 27 per cent for royalties, interest and royalties arising in India and paid to an Irish resident are subject to a lower withholding tax of 10 per cent under the Ireland–India DTAA.
In 2013, India blacklisted Cyprus as a non-cooperative jurisdiction, for not providing financial information sought by the Indian government to curb money laundering. This stand was reversed in November 2016, when India and Cyprus inked a new DTA to bring the provisions up to par with the India–Mauritius DTA. The DTA also provides for assistance between the two countries for exchange of information between the two nations, which will be used for purposes other than taxation.
iii Investment route for offshore funds
Investors typically route their investments in an Indian portfolio company through an FDI vehicle if the strategy is to play an active part in the business of the company. FDI investments are by way of subscription or purchase of securities, subject to compliance with the pricing guidelines, sectoral caps and certain industry-specific conditions. Such investments are governed by the rules and regulations set out under the consolidated foreign direct investment policy dated 4 January 2018, issued by the Department of Industrial Policy and Promotion (the FDI Policy) and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2017 (FEMA 20R). Previously, any investment in excess of the sectoral caps or not in compliance with the sectoral conditions required prior approval of the Foreign Investment Promotion Board (FIPB). In furtherance of its announcement in 2017, the government of India abolished the FIPB in 2017. In place of the FIPB, the government of India has introduced an online single point interface for facilitating decisions that were taken earlier by the FIPB. Upon receipt of an FDI application, the concerned administrative ministry or department will process the application in accordance with a standard operating procedure to be followed by investors and various departments of the government of India to approve foreign investment proposals. As a part of its initiative to ease business further, the SOP also sets out time limit of four to six weeks within which different departments of the government of India are required to respond to a proposal.
Foreign investors who have a short investment horizon and are not keen on engaging in the day-to-day operations of the target may opt for this route after obtaining prior registration as a foreign portfolio investor (FPI) from designated depository participants under the SEBI (Foreign Portfolio Investors) Regulations 2014 (the FPI Regulations). In 2014, in order to rationalise different routes for foreign portfolio investments and create a unified and single window framework for foreign institutional investors, qualified institutional investors and sub-accounts, the security watchdog, Securities and Exchange Board of India (SEBI), introduced the FPI Regulations. The regulations impose a ceiling on the individual holding of an FPI below 10 per cent of the capital of the company and the aggregate limit for FPI investment to 24 per cent of the capital of the company. This aggregate limit of 24 per cent may be increased up to the sectoral cap or statutory ceiling, as applicable, subject to, inter alia, prior intimation to the Reserve Bank of India (RBI). FPIs need to be registered with a designated depository participant before dealing with securities as a foreign portfolio investor. The process is fairly simple, and ordinarily it does not take more than 30 days to obtain the certificate.
Under the current FPI regime, Category I FPIs are restricted to those who are resident of a country whose securities market regulator is either a signatory to International Organization of Securities Commission’s Multilateral Memorandum (IOSCMM) or has a bilateral MoU with SEBI. Category I entities are essentially governments and related entities or multilateral agencies and are perceived to be the highest-quality and lowest-risk investors. To increase the volume of investments through FPI route, the SEBI is proposing to expand the list of eligible jurisdictions by including additional countries that have diplomatic tie-ups with India.
The FVCI route was introduced with the objective of allowing foreign investors to make investments in venture capital undertakings. Investment by such entities into listed Indian companies is also permitted subject to certain limits or conditions. Investment under the FVCI route requires prior registration with SEBI under the Securities and Exchange Board of India (Foreign Venture Capital Investors) Regulations 2000 (the FVCI Regulations). Investment companies, investment trusts, investment partnerships, pension funds, mutual funds, endowment funds, university funds, charitable institutions, asset management companies, investment managers and other entities incorporated outside India are eligible for registration as FVCIs. One of the primary benefits of investing under the FVCI route is that FVCI investments are not subject to the RBI’s pricing regulations. FVCIs should obtain a registration from SEBI before making investments under the FVCI Regulations. The process typically takes 20–30 days from the date of application. In order to promote job creation and innovation, the RBI allowed for 100 per cent FVCI investment in start-ups. Previously, it was restricted to biotechnology, IT, nanotechnology, seed research and development, discovery of new chemical entities in the pharmaceutical sector, dairy industry, poultry industry, production of bio-fuels, hotels and convention centres with a seating capacity of over 3,000, and the infrastructure sector: the approval of the securities regulator was not needed for invesment in these sectors.
iv Structure of domestic funds and opportunities for funding
Alternative investment funds
In 2012, SEBI introduced the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) to regulate privately pooled investment vehicles that collect funds from investors. The AIF Regulations replace the earlier regulatory framework of the SEBI (Venture Capital Funds) Regulations 1996, which covered funds that primarily invested in unlisted venture capital undertakings.
Based on the nature of the funds and their investment focus, the AIF Regulations categorise funds into Category I AIF,37 Category II AIF38 and Category III AIF.39 Such categories of funds also have distinct investment conditions and restrictions to comply with during their life.
The AIF Regulations prescribe, inter alia, a cap on the number of investors pooling into the AIF to 1,000, conditionality on the minimum corpus for the fund and a minimum amount to be invested by an investor. In order to align the interests of the investors and the promoters or sponsors of the fund, the sponsor or manager of the AIF is required to have a continuing interest in the AIF through the life of such AIF. Further, investment by the sponsor or manager of a Category I AIF and Category II AIF needs to be at least 2.5 per cent of the corpus (at any given point) of the AIF or 50 million rupees, whichever is lower.
Before commencing operations, AIFs should obtain a registration from SEBI, which takes about four to six weeks.
National investment and infrastructure fund
Pursuant to a proposal made in the Union budget in 2015, the government of India created the National Investment and Infrastructure Fund (NIIF) under the AIF Regulations to maximise infrastructure development in commercially viable projects. With a total corpus (e.g., the total amount of funds or investments available) of US$6 billion and the government pumping in half the corpus, the remaining investment was expected to come from overseas sovereign, quasi sovereign, multilateral or bilateral investors. In 2017, the government of India signed memorandums of understanding with Qatar Investment Authority and Russia’s Rusnanco OJSC to make investments to NIIF.
REITs and infrastructure investment trusts
In 2014, SEBI notified the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations 2014 (the REIT Regulations) and the SEBI (Infrastructure Investment Trusts) Regulations 2014 (the Infrastructure Regulations) to regulate investments in the real estate sector and infrastructure sector respectively.
Both the regulations are along the same lines, including conditions in relation to the investment and borrowing powers, the process for listing and trading of units, net worth and experience requirements, rights and obligations of different entities involved and valuation of assets and the distribution policy. The distinguishing feature is that the Infrastructure Regulations exclude projects that generate revenue or profit from rental or leasehold income. 2017 also witnessed Blackstone and its Indian partner Embassy group laying the groundwork for India’s first REIT. Finishing touches are being given by the group to the plan to raise nearly US$6 billion through an REIT. Hopefully other PE players will follow suit to stimulate the growth in an otherwise unattractive sector for investment. 2018 will see the introduction of monetary penalties if a person fails to comply with the provisions in relation to REITs and infrastructure investment trusts.
Foreign investment in domestic funds
Until 2015, these investment vehicles were heavily funded by domestic investors since prior permission of the FIPB was required if the overseas funds intended to directly invest in a privately pooled vehicle in India. In order to increase the participation of offshore funds in these investment vehicles, in November 2015, the RBI permitted such investment vehicles to receive investments from non-resident Indian investors, FPIs and foreign investors under the automatic route, as long as control of such investment vehicles vested in the hands of sponsors and managers or investment managers, that are Indian-owned and controlled under the foreign extant regulations. With the announcement, the total amount of funds raised and investments made by AIFs is increasing exponentially with 2017 witnessing an inflow that is more than double the amount raised in 2016.40 In 2017, the AIF industry attracted investments from a very unlikely category of investors (i.e., high net worth individuals) both from India and outside India. High valuations of certain companies and limitations with respect to traditional modes of investments has prompted this interest.
III INCREASED OPPORTUNITIES OWING TO THE INSOLVENCY CODE
One of the landmark reforms in India has been the introduction of comprehensive laws on corporate rehabilitation, revival and insolvency in 2016 (the Insolvency Code). The Insolvency Code introduced a number of new concepts such as a dedicated regulatory authority, the Insolvency and Bankruptcy Board of India to oversee the process under the Insolvency Code, a tribunal to hear these matters, a time-bound process for reorganisation and cadre of specialised insolvency professionals to manage the insolvency, rehabilitation and winding-up process. 2017 was also a watershed year for the Insolvency Code (the Code) with nearly 2,434 cases being filed before the National Company Law Tribunal.
The framework of the Insolvency Code provides interesting opportunities to PE players to raise funds in the distressed sales market. For the first time in the Indian legal framework, the Insolvency Code provides for super senior rescue finance, where interim credit is provided to the corporate debtor in the insolvency resolution process. Such form of financing is already popular in the US market, where PE funds allocate funds to participate in this space. Forced asset sales under the resolution process has already given enough options for PE funds to undertake control deals or co-invest with other strategic buyers. In addition, many promoters of companies being dragged under the Insolvency Code are looking for funds with dry powder to counter hostile bids.
IV SOLICITATION, DISCLOSURE REQUIREMENTS AND FIDUCIARY DUTIES
Typically, the investment vehicles issue a private placement memorandum (PPM) or an offer document in order to raise funds from prospective investors. The PPM sets out all material information to enable the investors to make an informed decision, including fund structure, summary of key terms, background of the key investment team, risk factors, disciplinary history, risk management tools in Category III AIFs.
A lesson learned last year by the industry from the SEBI’s interpretation of the AIF regulations was for the investment manager to pay careful attention while drafting the investment objectives in the PPM.
SEBI reprimanded SREI multiple asset investment trust (SMIT) and SREI alternative investment managers for not making investments within the specified limits set out in its PPM. Industry experts have criticised the order as being misplaced considering that managers should be afforded the flexibility of conducting their business within the broad framework contained in the marketing document and the terms contained therein should not be given a strict interpretation.
With respect to offshore India-focused funds, the disclosure requirements, marketing guidelines, limits on solicitation are governed by the laws of the fund’s domicile or jurisdiction. While there is no regulatory framework governing the marketing documents of offshore India-focused funds, under the AIF Regulations, AIFs are required to disclose certain financial information, including sharing of valuation reports and filing of PPM with the SEBI, for the domestic funds. Further, there are limitations on the number of investors that an investment vehicle can attract. For instance, no scheme of an AIF (other than an angel fund) can have more than 1,000 investors.
Recognised as fiduciaries, directors of an investment vehicle are exposed to liabilities, arising out of breach of their duties towards the fund and its stakeholders. Accordingly, directors should be mindful of their duties and cast a supervisory role, during the entire cycle of a fund. For instance, at the time of fund formation, a director should ensure that the structure of the fund is tax-compliant, and that the information set out in the offer documents is not untrue or misleading. During the life of the fund, the directors should ensure policies regarding conflicts of interest are in place and adhered to.
Similar principles are built into the AIF Regulations and the REIT Regulations, which require the sponsor and the manager to act in a fiduciary capacity towards its investors and disclose any potential conflicts of interest.
i Taxation of foreign funds
Typically, India-focused offshore funds are organised in tax-friendly jurisdictions. However, with the adoption of the General Anti-Avoidance Rules (GAAR) from 1 April 2017, the Indian tax authorities will have the ability to treat arrangements outside India as an ‘impermissible avoidance arrangement’ if the main purpose of such arrangement is to obtain a tax benefit and such arrangement has no ‘commercial substance’. Mere location of the entity in a tax-efficient jurisdiction will not invoke GAAR. Accordingly, it is critical for a fund to adhere to the substance requirement to enable it to be eligible for tax treaty benefits. In addition, the tax authorities clarified that GAAR provisions may still be invoked in cases which there exists special anti-avoidance rules (SAARs) or where arrangements are covered under treaties with a limitation of benefits provisions. In a rather disappointing move, the taxation authorities failed to issue a clarification on whether long-standing structures will be under the scrutiny of GAAR.
Further, there is a potential risk of taxation of offshore funds in India on account of two factors:
- association of persons: tax laws in India recognise the concept of an association of persons as a separate taxable entity. This means that if a foreign fund along with a domestic fund come together with a common purpose to earn income, it may be viewed as a potential association of persons, which is a separate taxable entity under Indian taxation laws; and
- permanent establishment in India: in addition, there is a risk of an offshore fund being perceived to have a ‘permanent establishment’ in India on account of its relationship with the investment advisory team based out of India, in which case it will be liable to tax in India. In order to determine the actual residency status of an entity, the concept of ‘place of effective management’ (POEM) was introduced in 2015 and the regulatory framework in put in place in early 2017 (the POEM Guidelines). Under the POEM Guidelines, the key guiding principle to determine POEM is whether or not the entity is engaged in ‘active business outside India’. The government of India has proposed a couple of changes to expand the concept of business connection to impose taxes on foreign enterprises. The present definition covers within its ambit such scenarios where the foreign enterprise actually undertakes physical business activities in India or regularly concludes contracts through a dependent agent. The proposal is to move the business connection from the formal conclusion of contracts to include merely the negotiation of contracts. In addition, a foreign enterprise need not have a physical presence in India. Enterprises with a digital and a significant economic presence is sufficient to demonstrate a business connection with India.
ii Taxation of domestic funds
The Finance Act 2015 conferred tax pass-through status upon Category I and Category II AIFs. Accordingly, the income from investment is not taxed in the hands of such funds but is taxed in the hands of the unit holders. The taxation of Category III AIFs depends on the legal status of the fund (i.e., company, limited liability partnership or trust). Accordingly, income of the investment fund, other than the business income, is exempt from tax and income received by or accrued to the unit holders of the Category I and Category II AIFs is chargeable to tax in the same nature and in the same proportion as if it were income received by or accrued to such unit holder had the investment been made directly by him or her. This amendment has provided long-awaited clarity to AIFs given that prior to this amendment, AIFs were subject to trust taxation provisions that posed several tax uncertainties.
On similar lines, amendments were made to provide a pass-through status to REITs. Taxes on REITs are imposed in the manner set out below:
DDT of 15 per cent (on gross up basis)
Further, tax implications on different streams of income in the hands of the investors are set out below.
Dividends declared by Indian companies are exempt from tax in the hands of the investors. The investee companies are liable to pay dividend distribution tax on the net dividend distributed in the hands of the investee companies. To curb companies that enter into schemes of amalgamation for avoidance of a dividend distribution tax, the government in its budget announcement proposed the widening of the scope of ‘accumulated profits’ to include the profits of the amalgamating company and amalgamated company.
Interest income is subject to tax in the hands of the Indian resident investors at the rate that would otherwise apply to such investors on their ordinary income. In the case of FIIs and FPIs, income from interest on income is taxed at 20 per cent. Income from interest on a rupee-denominated bond or a government security is 5 per cent.
Any short-term capital gain arising on the transfer of listed shares either on the stock exchange or in an offer for sale is subject to a tax of 15 per cent, provided that the transaction has been subject to securities transaction tax (STT). Presently, long-term capital gain arising on such a transfer of any shares where STT has been paid is exempt from taxation. The government of India in its budget announced the withdrawal of such capital gains exemption. The proposal provides a limited grandfathering benefit to the long-term capital gains earned on the equity instruments acquired prior to 1 February 2018.
Vi KEY INVESTMENT TERMS
Owing to increased investment opportunities and a stable government, foreign LPs are definitely stepping up their allocations in India focused funds. Trends also indicate LPs playing a more active role to monitor the allocation of such funds.
From a monitoring perspective, although LPs are not directly engaged in conducting the due diligence of the portfolio companies, they are keeping a close tab on the sectors in which their funds are being pumped in. To have a sufficient say in the decision making process, LPs are pushing for a detailed decision making process with their representatives having sufficient powers to veto an investment decision if need be. Representation on investment and advisory committees have become contentious points of negotiations amongst LPs and GPs. LPs are also demanding a veto right with respect to critical decisions such as capital deployment, appointment of key man, conflict of interest and sector focus. Such increased involvement of LPs in the decision making process can be attributed to poor exit track record, information asymmetry on the investments made in the past and instances of negligence and mismanagement of funds by GPs in the past. A positive trend that we have been witnessing is LPs getting involved with the day-to-day operations of the portfolio companies and sharing their sectoral expertise to expand their business. With many DFIs acting as LPs, funds are being compelled to follow international benchmarks with respect to governance, anti-corruption, environmental and social norms.
In relation to the management fee aspects, the story in India is no different from the global trend. There is increased resistance to adhere to the 2 and 20 fee-carry model. GPs have accepted positions where the management fee is calculated as a percentage on the amount of unreturned capital contribution of the LPs. LPs have successfully managed to negotiate discounts on deal fees with GPs as well. The Indian private equity space is increasingly witnessing GPs offering co-investment structures to LPs that results in an overall reduction in fees that LPs pay to GPs. To diversify an LP’s risk, waterfalls are being structured to allow for LPs to invest on a deal-by-deal basis or on a blind pool basis. In addition, at the time of formation of the fund itself, GPs are asked to provide a fee model to act as a guide to analyse and set management fees.
Owing to the administrative hassle of managing too many GP relationships, powerful and large LPs are cherry picking the GPs they want to deal with. LPs are willing to bet their money on decently sized GPs who have a consistent track record. The operational due diligence on GPs has become highly detailed with meticulous data analysis being conducted as a part of the GP selection process. Other than the standard performance metrics, such as internal rate of return, detailed past-performance figures are being taken into account while conducting due diligence.
A situation that most LPs are jostling with is to get all the LPs to behave collectively when they intend to pool their funds into a fund. Barring a few powerful LPs, an LP individually is not that powerful. Opinions are divided on what issue should be taken up on priority and what changes are acceptable. This gives GPs a slight edge while negotiating the deal.
With increased scrutiny of the fund structures by tax authorities, GPs have successfully negotiated for a clawback clause from LPs to cover for any future tax liabilities. While LPs fight to limit the scope of such provisions to a certain time period, it may not be acceptable in the Indian context considering given the long limitation period available to the tax authorities to proceed against the funds.
The changing dynamics between LPs and GPs has given both the parties an opportunity to remould the Indian private equity space into a more sophisticated market. Practically speaking, perfect alignment of interests between the LPs and GPs is close to impossible. However, if Indian GPs have to keep the funds flowing from LPs, GPs need to get into the habit of making adjustments to the agreed fund terms and conditions.
VIi REGULATORY DEVELOPMENTS
i FDI policy: liberalisation and FIPB
The past few months saw the FDI policy being further liberalised as follows:
- permissible foreign investment has been increased in the national aircraft carrier (Air India) up to 49 per cent under the approval route (previously no foreign investment was allowed in the national aircraft carrier);
- investment by FPI/FIIs in power exchanges has been permitted through primary market as well (previously investment was allowed only through the secondary market); and
- foreign investment in single brand retailing has been up to 100 per cent under the automatic route (previous). Further, the single brand retailing entity (SBRT) has been permitted to set off its ‘incremental sourcing’ of goods from India for its global operations for the initial five years beginning 1 April of the year in which the first store is opened. Prior to this there was a mandatory sourcing requirement of 30 per cent purchase from India. ‘Incremental sourcing’ means the increase in terms of value of such global sourcing from India for that single brand in a particular financial year over the preceding financial year, by the non-resident entities undertaking SBRT either directly or through their group companies. After completion of this five-year period, the SBRT entity is required to meet the 30 per cent sourcing norms directly towards its India operation, on an annual basis.
From an operational perspective, with the abolition of the Foreign Investment Promotion Board (FIPB), the Department of Industrial Policy and Promotion (DIPP) has released the standard operating procedure (SOP) for processing FDI proposals, which has simplified the process and expedited the timelines involved in approval of projects or investments which need the governmental nod.
ii Antitrust rules: target exemption extended
2017 witnessed the merger control regime undergoing certain amends to align itself with global standards and ease the process of closing complex cross-border deals in India. The target entity that did not meet the asset and turnover thresholds of approximately US$38 million and US$115 million respectively did not need to be notified for antitrust approval. The target exemption was valid from 2011 until 2016. In 2017: (1) the target exemption thresholds were increased to US$52 million for assets and US$148 million for turnover; and (2) the validity of the target exemption has been extended until 4 March 2021; (3) the scope of the target exemption has been clarified to apply only to the assets and turnover of the target and not the assets and the turnover of the selling entity; (4) the obligation to notify transactions within 30 days from the relevant trigger event has been dispensed with. This dispensation to notify transactions is consistent with the approach adopted globally.
iii REITS and InvITs
In order to facilitate the growth of infrastructure investment trusts (InvITs) and real estate investment trust (REITs), SEBI allowed REITs and InvITs to raise debt capital by issuing debt securities. SEBI also introduced the concept of strategic investor for REITs, as for InvITs, to include an infrastructure finance company registered with RBI as a non-banking financial company, a scheduled commercial bank, an international multilateral financial institution, systemically important NBFC registered with the RBI or an FPI, who together invest not less than 5 per cent of the total offer size of the InvIT or such amount as may be specified by the SEBI. The Insurance Regulatory and Development Authority (IRDA) and the Reserve Bank of India (RBI) have allowed banks and insurance companies to invest in REITs, subject to certain conditions.
iv PE in insurance
As a response to keen interests shown by private equity players in the insurance sector, the IRDA issued guidelines for private equity funds and Alternate Investment Funds (AIF) intending to assume the role of promoters in the company. The guidelines impose an individual ceiling of 10 per cent on investors and an aggregate ceiling of 25 per cent of the paid-up equity share capital by Indian investors including PE funds. A PE fund is allowed to act as a promoter of one life insurer, one general insurer, one health insurer and one reinsurer. Investments made by special purpose vehicles are subject to a lock-in of five years. With capital scarcity and Indian families acting as promoter groups, the guidelines pave the way for professionals in the sector to assume the role of promoters. This also serves as a catalyst for enabling incremental flow of FDI in this sector.
v Withdrawal of long-term capital gains tax exemption
The recent announcement to withdraw the long-term capital gains tax exemption on sale of listed equity shares on the stock exchange was welcomed by the private equity and venture capital funds. Bringing in parity on taxation of gains from investments in listed and unlisted companies is going to result in increased capital allocation towards private equity and venture capital classes.
The introduction of the GST and domestic demonetisation movement as well as certain global factors and the economic growth rate in India during the first half of 2017 affected the volume of fundraising and PE investments in 2017. However, the strong ‘fundamentals’ of India (a knock-on effect from demonetisation), the government’s constant efforts to liberalise the FDI policy, new avenues pursuant to the enactment of the Bankruptcy Code and a buoyant stock market are expected to continue to create a positive outlook for India.
With an excellent year for capital markets behind us and record-breaking number of companies going public, which indicates a better exit environment, we expect the GPs and LPs to further strengthen their outlook towards India. We expect fundraising activity in India to continue with the momentum.
From a sector and size perspective, we expect investors to closely watch the infrastructure space with many distressed sales coming up for acquisition. Fintech is another sector that will likely keep the investors engaged, with India moving towards a cashless economy. Education, insurance and the hospitals sector should also receive significant interest considering the tremendous scope for growth in these sectors in India.
Lastly, with the government and Indian corporates recognising the role of PE and striving to build a robust PE ecosystem, it will not be surprising if global PE funds allocate significant investment to India.
1 Raghubir Menon and Ekta Gupta are partners, Deepa Rekha is a senior associate, and Srishti Maheshwari is an associate at Shardul Amarchand Mangaldas & Co.
12 VCCircle Flashback 2017.
37 An AIF that invests in start-up or early stage ventures or social ventures or small and medium enterprises or infrastructure or other sectors or areas that the government or regulators consider as socially or economically desirable (including venture capital funds, SME funds, social venture funds, infrastructure funds, angel funds and such other AIFs as may be specified).
38 An AIF that does not fall into Category I and III and does not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted under the AIF Regulations, will be a Category II AIF.
39 An AIF that employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives will be a Category III AIF. AIFs such as hedge funds or funds that trade with a view to make short-term returns or such other funds that are open ended can be included.