i GENERAL OVERVIEW

The private equity (PE) landscape in India entered a matured phase in 2018 with consistent investment inflow, an increase in the number of exits and continued accumulation of dry powder. Certain trends unique to 2018 are worth noting.

Renewed interest shown by global PE and M&A investors in India and an expanding footprint of global pension funds and sovereign wealth funds in India (by stepping up their investments in the infrastructure and real estate sectors)2 were reassuring for the Indian market. There was a sudden spike of interest in stressed assets because of the enactment of the Insolvency and Bankruptcy Code (which also took India higher up on the World Bank's ranking for ease of doing business).3 The resultant increase in the sale of stressed assets offered new opportunities to PE funds.4 There was a shift in focus on governance and deleveraging as a result of which the number of control deals and buyouts increased in 2018.5

There was an increase in deal values (despite the decline in deal volumes), namely a surge in billion-dollar deals. 2018 also saw a drastic increase in exit activity, evidenced by the fact that exits worth approximately US$25 billion were recorded in 2018, compared with US$14 billion in 2017.6 In addition, secondary sales gained importance as a mode of exit in comparison to initial public offerings (IPOs), the most popular exit mode in 2017.7

i 2018 v. 2017

The highest-ever fundraising total was recorded in 2018, with US$8.1 billion raised across 51 funds and US$22.3 billion worth of fundraising plans announced. The total amount of funds raised through the year shows a 40 per cent increase in comparison to 2017's total, which had a reported aggregate fundraising total of US$4.9 billion. While the year had a tepid start, with US$3.1 billion being raised in the first quarter of 2018 (which was on a par with the fundraising activity in the first quarter of 2017),8 the second quarter of 2018 came out strong, with US$1.7 billion raised, as against US$719 million raised in the second quarter of 2017. As result, the first half of 2018 showed a 50 per cent increase in fundraising when compared to 2017, with a reported US$3 billion worth of funds raised.9 The third quarter saw the highest-ever quarterly fundraising figures at US$2.6 billion (a 17 per cent increase from 2017).

The largest fundraising of 2018 was also the largest logistics real estate fund ever raised in India. This was the US$1.2 billion real estate fund raised by IndoSpace, a leading developer of industrial real estate and warehousing facilities in India.10 Sequoia raised US$695 million for its sixth India-focused fund, which will focus on early and growth stage investments in the technology, consumer and healthcare sectors.11 The US$600 million buyout fund raised by True North Capital (formerly India Value Fund Advisors) was the third-largest fund raised in 2018 and is expected to raise an additional US$900 million, underlining global investors' faith in Indian fund managers.12 Other significant fund raises were the funds raised by Godrej Fund Management: (1) US$450 million for Godrej Build To Core-I, an office investment fund, and (2) US$150 million for Godrej Office Fund-I, a discretionary blind pool fund.13 Motilal Oswal Private Equity Advisors Pvt Ltd raised its third fund, India Business Excellence Fund III. This is its largest-ever fundraising, at approximately US$330 million, of which almost 75 per cent was contributed by domestic investors. The fund will focus on the financial services, consumer and healthcare sectors.14 Nexus Venture Partners, one of India's leading home-grown venture capital (VC) firms, raised US$313 million (70 per cent of the targeted US$450 million) for its sector agnostic fund.15 Evidently, the most significant fundraisings of 2018 were by home-grown funds.

In addition to the funds raised, some significant fundraisings are in the pipeline. The National Investment and Infrastructure Fund and DP World Private Limited announced their plans to raise a US$3 billion fund to invest in ports, terminals, transportation and logistics businesses in India.16 The Global Steering Group for Impact Investment, successor to the Social Impact Investment Taskforce established by the G8, proposes a massive fundraising of US$2 billion (through two funds of US$1 billion each) to invest in social enterprise initiatives in India.17 Further, Everstone Group and Lightsource BP have entered into a joint venture to set up the Green Growth Equity Fund, a US$710 million fund to invest in the infrastructure and energy sector in India.18

ii Industry sector trends

Unlike in 2017, sector agnostic funds did not dominate fundraising activity in 2018. In a continuation of the trends seen in previous years, the real estate, consumer technology and financial services sectors witnessed a substantial amount of fundraising activity. There were two significant fundraisings in the small and medium-sized enterprise sector: the US$200 million fund raised by the Indian subsidiary of the Industrial and Commercial Bank of China to invest in local start-ups and small firms,19 and the US$127 million fund raised by IndiaNivesh, its maiden fund, which will focus on turnaround opportunities among small and medium-sized enterprises.20 The state government of Rajasthan launched a US$77 million fund for promoting start-ups, with a part of the resources allocated for women-led start-ups and green-solution start-ups.21

iii Real estate and infrastructure

The real estate fund of US$1.2 billion raised by IndoSpace and the two funds (US$600 million in aggregate) raised by Godrej Fund Management were the largest real estate sector funds raised in 2018. Other real estate and infrastructure sector funds raised or announced include the US$300 million India-focused infrastructure fund raised by Morgan Stanley,22 the US$218 million fund (India Realty Excellence Fund I) raised by Motilal Oswal Real Estate, the US$297 million fund raised by Edelweiss Alternative Asset Advisors for investment in the infrastructure sector,23 and the US$208 million fund announced by realty firm Puravankara.24

iv Sector agnostic funds

The US$600 million buyout fund raised by True North Capital25 and the US$313 million fund raised by Nexus Venture Partners26 were among the significant sector agnostic fundraisings in 2018. In addition, SeaLink Capital announced the closure of its US$315 million maiden fund, a sector agnostic that will focus on medium-sized companies.27 Greater Pacific raised US$300 million in the first close of its targeted US$700 million fund, which will target investment opportunities greater than US$50 million in value in sectors such as healthcare, technology and services.28 AION Capital, a joint venture between Apollo Global and ICICI Venture, has announced its second fund (which will be a sector agnostic fund) with a targeted corpus of US$1 billion.29 Lastly, the Lighthouse fund, an India-focused PE fund, raised a US$200 million fund to invest in small consumer-driven ventures.30

v Financial services and consumer technology

India Business Excellence Fund III, Motilal Oswal Private Equity Advisors Private Limited's third fund of US$330 million, which will focus on the financial services, consumer and healthcare sectors.31 Sequoia's US$695 million India-focused fund has been raised for early and growth stage investments in the technology, consumer and healthcare sectors.32 Lightbox Ventures raised US$178 million out of the targeted US$200 million for its third fund, which will focus on investments in fast-moving consumer goods, financial services, education and healthcare.33 Matrix Partners India raised US$300 million for its third India-dedicated fund for investment in consumer technology.34 The US$113 million fund raised by TVS Capital will focus on financial services and the healthcare sector.35

vi Investments and exits

The investment trends in 2018 were reflective of the growing maturity of the Indian market as 2018 saw more nuanced and high-value PE investments. The total investment value (at US$35.1 billion) increased by 35 per cent in comparison to 2017 (US$26.1 billion). There were 12 deals of value greater than US$500 million (including eight deals of value greater than US$1 billion) during the year.36 The US$1.7 billion investment by GIC, KKR, PremjiInvest and OMERS in HDFC Limited for a minority 3.9 per cent stake was one of the largest deals.37 Other prominent deals were the US$1.3 billion investment by a consortium of Warburg Pincus, Softbank, Temasek and other global investors for acquisition of a 28 per cent stake in Airtel Africa,38 the US$1 billion investment in hospitality-tech start-up Oyo Rooms by Greenoaks Capital, SoftBank, Lightspeed Ventures and Sequoia Capital,39 and the US$1.6 billion investment by Macquarie Group in the National Highways Authority of India's Toll-Operate-Transfer Bundle I.40

There was a strong uptick in investments in the infrastructure and real estate sector. Buyouts were at an all-time high, as evidenced by 48 buyouts at US$9.8 billion in aggregate (roughly equal to the combined value of the buyouts from the previous three years).41 The increase in buyout deals reflects a clear shift in focus from growth capital or minority deals to control deals. KKR's acquisition of a majority stake in Max Healthcare42 and a 60 per cent stake in Ramky Enviro Engineers43 were among the significant buyout deals of 2018. The US$1.6 billion investment by Macquarie Group in National Highways Authority of India's Toll-Operate-Transfer Bundle I,44 the acquisition of Equinox Business Park by Brookfield for US$384 million,45 the acquisition of information technology (IT) park SP City by Temasek (through Mapletree Investments) for US$353 million,46 the buyout of Phoenix Group's office project in Hyderabad by Xander for US$350 million,47 and the buyout of Indiabulls Properties Private Limited by Blackstone for US$346 million were the noteworthy deals in the infrastructure and real estate sector, as well as being the largest buyout deals of 2018.

After peaking in 2015 and then declining in 2016 and 2017, investments in start-ups increased dramatically in 2018 and surpassed the record set in 2015.48 The largest deals were the US$1 billion investment by Softbank, Sequoia and Lightspeed in Oyo Rooms,49 the US$1 billion investment in Swiggy (food delivery mobile application) by DST Global, Naspers, Tencent and Hillhouse Capital,50 and the US$1 billion investment by Warburg Pincus to set up a business processing management platform, Vivtera, in association with Indian former IT executives.51 Private investment in public equity, a major trend in 2017, saw a meagre 3 per cent increase, which can be attributed to the volatile market conditions in the second half of 2018.52

The past year was a phenomenal one for exits. The value of PE/VC exits was US$26 billion, which is an increase of nearly 100 per cent compared with the value of exits in 2017, and is equal to the combined value of exits over the previous three years. While Walmart's US$16 billion acquisition of Flipkart from multiple investors (including Softbank and Tiger Global) contributed significantly to this increase, strategic and secondary exits increased markedly in 2018. The strategic sale of business process outsourcing firm Intelenet Global Services Private Limited by Blackstone for US$1 billion,53 the US$769 million buyout of Vishal Mega Mart Private Limited by Partners Group and Kedaara Capital,54 and the secondary acquisition of Star Health and Allied Insurance Company Limited by WestBridge Capital and Madison Capital for US$745 million55 were the largest secondary or strategic exits of 2018. Open market exits and PE-backed IPOs, on the other hand, slowed down this year (declining by more than 70 per cent in terms of value, and by more than 56 per cent in volume in comparison to 2017) because of the volatility in the market caused by global trade wars and the headwinds on the Indian macroeconomic front.56

vii Reception by limited partners and fund managers

India has proven to be a volatile market, with drastic upward and downward trends in its perceived attractiveness over the past few years, starting in 2008 when it ranked second, then in 2014 falling down to the eighth spot, then topping the list in 2017 before slipping to the second spot to 2018.57 In this context, according to a market survey conducted by the Emerging Markets Private Equity Association, better opportunities for growth, the increasing number of exits and improved choices in fund managers have been cited as factors that make India attractive, while the perceived competitiveness of the investment environment due to its increasing attractiveness and high entry valuations have been cited as deterrents.58

Given the importance placed on exit prospects by PE investors and the fact that a weak exit environment in India has been cited as a deterrent for investment in the past, the increase in exit activity has instilled confidence in investors by showing that investments in India hold promise and this has resulted in liquidity of funds for further investments.59 However, India still faces the problem of lack of local participation in funds and fund management. This can be attributed to funds not being allocated to India by the India-based private equity investors, as well as to regulatory factors that do not encourage pooling of funds in India.60

While 2018 ended on a high note, an uncertain political environment in India owing to the impending general elections in 2019, the volatility of the Indian rupee and the detrimental effect of the surge in oil prices on India's fiscal condition are factors that are likely to impact PE activity in India.61 However, with the positive global outlook on India intact, and fair returns on investment coupled with increasing investment opportunities, limited partners (LPs) and fund managers continue to remain hopeful.

II LEGAL FRAMEWORK FOR FUNDRAISING

i Offshore structures

Foreign investors have always opted for a jurisdiction that provided tax neutrality to them with respect to their investments in India. 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, the taxation implications are nullified and the Indian income tax laws apply only to the extent they are more beneficial than the tax treaties. Accordingly, most India-focused funds are based out of either Singapore or Mauritius as a limited liability partnership (LLP) or a corporate entity. Further, the general partner (GP) and the investment manager, who set up and operate the investment vehicle, are located outside India.

ii Tax risks re offshore structures

To curb tax avoidance, the government introduced the General Anti-Avoidance Rule (GAAR), with effect from the financial year beginning on 1 April 2017. The introduction of GAAR has provided the tax authorities with the ammunition to recharacterise a transaction or an arrangement such that it gets taxed on the basis of substance, rather than on its form. The consequences include investment vehicles being denied DTA benefits or reclassification of capital gains as any other income, or a combination of these. In addition, the government amended the criteria for determining the tax residence of offshore companies by introducing the place-of-effective-management (POEM) guidelines, with effect from 1 April 2017. According to the POEM guidelines, if the key management and commercial decisions that are necessary to conduct the business of any entity as a whole are, in substance, made in India, an offshore entity could be construed as being tax resident in India.

The past two years also witnessed India renegotiating its DTA agreements with Singapore and Mauritius, making these less attractive as fund jurisdictions. The details of these changes along with an analysis on the future of these countries as viable fund jurisdictions is set out in detail below.

iii Rise of unified structures with direct investment by LPs

The fear of tax exposure owing to the various changes set out above has led to investors exploring unified structures or co-investment structures. Under the unified structure, both domestic and foreign investors make their investments into a domestic pooling vehicle. These unified structures received a huge impetus in 2015.

Until 2015, these investment vehicles were heavily funded by domestic investors since prior permission from the Foreign Investment Promotion Board was required if the overseas funds intended to directly invest in a privately pooled vehicle in India. To increase the participation of offshore funds in these investment vehicles, as of November 2015, the Reserve Bank of India (RBI) has permitted such investment vehicles to receive investments from non-resident Indian investors and foreign investors through the automatic route, as long as control of the investment vehicles vests in the hands of sponsors and managers, or investment managers, that are considered Indian-owned and controlled under the extant foreign regulations; investments by Indian-controlled alternative investment funds (AIFs) with foreign investment are thus deemed to be domestic investments.

iv Legal framework of domestic funds

Alternative investment funds

Prior to private equity capital gaining popularity, entrepreneurs relied heavily on loan capital raised from banks and financial institutions, public issuances and private placements. Realising the potential role of PE funds and the value addition they would contribute to the growth of corporate entities, the Securities and Exchange Board of India (SEBI) introduced a set of regulations governing investments by venture capital companies. This was followed by an overhaul in the regulations in 2012 with the introduction of the SEBI (Alternative Investment Funds) Regulations 2012 (the AIF Regulations) to regulate privately pooled investment vehicles that collect funds from investors on a private placement basis. 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.

Under the AIF Regulations, an AIF is a privately pooled investment vehicle incorporated in the form of an LLP, trust or body corporate, which collects funds from Indian and foreign investors for investments in accordance with a defined investment policy for the benefit of its investors.

Based on the nature of the funds and their investment focus, the AIF Regulations categorise funds into Category I AIF,62 Category II AIF63 and Category III AIF.64 These categories of funds must also comply with distinct investment conditions and restrictions during their life.

The AIF Regulations prescribe, inter alia, a cap of 1,000 on the number of investors pooling into the AIF, conditionality on the minimum corpus for the fund and a minimum amount to be invested by an investor. 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 throughout the life of the AIF. Further, investment by the sponsor or manager of a Category I AIF and Category II AIF has to be at least 2.5 per cent of the corpus (at any given point) of the AIF or 500 million rupees, whichever is lower.

Before commencing operations, AIFs should register with SEBI, which takes about four to six weeks. An AIF can be set up in the form of a trust, a company, an LLP or a body corporate. Most funds in India opt for the trust structure. The entities involved in the structure are a settlor, a trustee and a contributor. The settlor settles the trust with a small amount as an initial settlement. The trustee is appointed to administer the trust and is paid a fee in lieu of such services. The investor signs up to a contribution agreement to make a capital commitment to the fund.

Sector-focused fund structures

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 and infrastructure sectors respectively. An infrastructure investment trust (InvIT) and a real estate investment trust (REIT) must register with SEBI to conduct their business.

An REIT is a trust formed under the Indian Trust Act 1882 (the Trust Act) and registered under the Registration Act, 1908 (the Registration Act) with the primary objective of undertaking the business of real estate investment in accordance with the REIT Regulations and has separate persons designated as sponsor, manager and trustee. The REIT is created by the sponsor of the trust, the trustee oversees the entire REIT and ensures all rules are complied with, and the beneficiaries are the unitholders of the REIT. The parties involved in the establishment of the REIT are: (1) the sponsor; (2) the trustee; (3) the investment manager and (4) the valuer. The sponsor is responsible for the creation of the trust. Each REIT is allowed to a have a maximum of three sponsors, with each of them having a net worth of not less than 200 million rupees and a collective net worth of not less than 1 billion rupees. The sponsor should have not less than five years' experience in the development of the real estate sector. The trustee is the owner of the REIT assets, which it holds for the benefit of the unitholders, and it oversees the activities of the manager. The investment manager enters into an investment management agreement with the trustee and makes the investment decisions for the REIT. The responsibility of the valuer is to conduct half-yearly and annual valuations of the REIT's assets. The REIT Regulations impose a restriction on an REIT to invest only in special purpose vehicles (SPVs) or properties or transfer development rights in India or mortgaged-backed securities. An REIT is allowed to make an initial offer of its units only through a public issue. No such offer can be made unless the offer size is at least 2.5 billion rupees and the value of the assets is not less than 5 billion rupees.

Akin to an REIT, an InvIT is a trust formed under the Indian Trust Act 1882 and registered under the Registration Act 1908. The InvIT is created by the sponsor of the trust, the ownership of the property vests in the trustee and the beneficiaries are the unitholders of the InvIT. It should be ensured that no unitholder of an InvIT enjoys superior voting rights or any other rights over another unitholder. Further, the Infrastructure Regulations prohibit multiple classes of units of InvITs. The SEBI InvIT Regulations require that an InvIT must hold not less than 51 per cent of the equity share capital or interest in the project SPVs. The parties involved in the establishment of the InvIT are: (1) the sponsor, (2) the trustee, (3) the investment manager, and (4) the project manager. The sponsor is responsible for the creation of the trust. The trustee is the owner of the InvIT assets, which it holds for the benefit of the unitholders. While the investment manager makes the investment decisions for the InvIT, the project manager is responsible for achieving the execution or management of the project in accordance with the Infrastructure Regulations.

The Infrastructure Regulations further require that the investment manager, in consultation with the trustee, is required to appoint the majority of the board of directors or governing board of the holding company and SPVs.

Both the Infrastructure Regulations and the REIT Regulations include conditions on 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 the 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.

In September 2018, Embassy Office Parks and Blackstone Group filed an offer document with SEBI for a 50 billion rupee issue. Hopefully other PE players will follow suit to stimulate growth in an otherwise unattractive sector for investment. In November 2018, SEBI amended the guidelines for public issues of REIT and InvIT units with a view to further rationalising and easing the issue process, the details of which have been set out below.

v Steps to popularise domestic funds as fund structures

Over the past year, the government has taken steps for mobilising domestic capital from banks, mutual funds and insurance companies. In fact, the Alternative Investment Policy Advisory Committee in its report submitted on 19 January 2018 recommended the use of domestic funds as they currently constitute only a minor percentage of the total funds invested annually. Under a domestic fund structure, the fund vehicle (typically a trust entity registered with SEBI as an AIF) is not to be taxed on any income that is earned from investments. The income earned is taxable in the hands of the investors when the venture capital fund or AIF distributes this the investors. Further, the characterisation of income in their hands is the same as that realised or distributed by the investee company to the fund. On 3 July 2018, SEBI raised the cap for overseas investments in AIFs and VCFs from US$500 million to US$750 million. Investments in 2018 in AIFs have risen 30 per cent up to 1.8 trillion rupees. Further, a restriction on allocating foreign portfolio investors (FPIs) more than 50 per cent of the securities in a single debt issuance prompted FPIs to use the AIF route to make debt investments into India.

ii Preferred jurisdictions for offshore funds

Background

As stated earlier, 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 DTA agreements with various countries, such as Ireland, Mauritius, the Netherlands and Singapore. 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 of the shares of an Indian company.

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 that provides various benefits, such as tax exemption on capital gains, a robust dispute resolution network and the right to repatriate capital and returns.

The benefits under the India–Singapore DTA are available only to entities that reside or are domiciled in Singapore. Further, the treaty benefits are linked to satisfaction of certain conditionalities, 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 itself of the capital gains exemption. In addition, the entity should not be a shell or conduit company.

Recent treaty changes

The bilateral investment treaty between India and Mauritius was amended on 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 the 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 phasing out of the capital gains exemption is only applicable to sales of shares and not sales of debentures. Accordingly, sales of debentures continue to enjoy tax benefits under the India–Mauritius DTA, making Mauritius a preferred destination for debt investments.

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 of Mauritius has introduced domestic substance rules to determine whether 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 investors time to reassess their investment structures in relation to India.

As stated earlier, the amendments to the India–Mauritius DTA have made it a significantly less popular destination for making investments. In addition, the announcement made by the Prime Minister of Mauritius in the country's budget in June 2018 indicates a potential three per cent tax liability on Mauritian FPIs earning dividend income from Indian shares.

The capital gains exemption under the India–Singapore DTA was coterminous 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 the Indian government to apply GAAR even in situations where a specific anti-avoidance provision exists in the DTA.

Singapore or Mauritius

Although Singapore is no longer a relevant jurisdiction for investors seeking to take advantage of tax arbitrage, Singapore is taking various steps to attract foreign investors, including by introducing the concept of a Singapore Variable Capital Company (SVCC) to be used as a vehicle for investment. The SVCC is expected to simplify the process of redemption of open-ended funds. Currently, the redemption of open-ended funds is a long-drawn-out process involving drawing up of accounts, audit and issuance of a solvency certificate. Singapore also enjoys an edge over Mauritius because of its outstanding banking facilities, access to financial products and better talent, thus causing a shift of funds from Mauritius to Singapore.

The choice of jurisdiction assumes more importance for FPIs since the securities held by an FPI are considered capital assets and the gains derived from their transfer are considered capital gains. Therefore, funds that have so far taken the position that this kind of income qualifies as business income may have to revisit their structures to ensure that they operate from jurisdictions that allow them to obtain relief on paying the applicable tax in India.

iii Investment route for offshore funds

Foreign direct investment route

Investors typically route their investments in an Indian portfolio company through a foreign direct investment (FDI) vehicle if the strategy is to play an active part in the business of the company. FDI investments are made 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 FDI consolidated policy (the FDI Policy), which is issued every year by the Department of Industrial Policy and Promotion (DIPP) of the Ministry of Commerce and Industry, and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations 2017 (FEMA20R). Under FEMA20R, any investment of 10 per cent or more of the post-issue paid-up equity capital on a fully diluted basis of a listed company shall be reclassified as FDI.

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 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 would previously have been taken by the FIPB. Upon receipt of an FDI application, the administrative ministry or department concerned will process the application in accordance with a standard operating procedure (SOP) to be followed by investors and various government departments to approve foreign investment proposals. As a part of its initiative to ease business further, the SOP also sets out a time limit of four to six weeks within which different government departments are required to respond to a proposal. One year on, there is very little information in the public domain about the proposals processed by the SOP.

FPI route

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 prior registration with a Designated Depository Participant (DDP) as an FPI under the SEBI (Foreign Portfolio Investors) Regulations 2014 (the FPI Regulations). In 2014, 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, SEBI, the security watchdog, introduced the FPI Regulations. The regulations impose a ceiling on the individual holding of an FPI, which must be below 10 per cent of the capital of the company, and an aggregate limit for FPI investment of 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 notice to the RBI. FPIs must be registered with a DDP before dealing in securities as an FPI. The process is fairly simple and ordinarily it does not take more than 30 days to obtain the certificate. Clubbing of investment limits for FPIs is done on the basis of common ownership of more than 50 per cent or based on common control. As regards common-control criteria, clubbing shall not be done for FPIs in the following cases: (1) FPIs that are appropriately regulated public retail funds; (2) FPIs that are public retail funds majority owned by appropriately regulated public retail funds on a look-through basis; or (3) FPIs that are public retail funds whose investment managers (IMs) are appropriately regulated. The term 'control' is understood to include the right to appoint a majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of shareholding or management rights or shareholders' agreements or voting agreements, or in any other manner.

Under the current FPI regime, Category I FPIs are restricted to those who are residents of a country whose securities market regulator is either a signatory to the International Organization of Securities Commission's Multilateral Memorandum (IOSCMM) or has a bilateral memorandum of understanding 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 the FPI route, SEBI is proposing to expand the list of eligible jurisdictions by including additional countries that have diplomatic tie-ups with India.

In December 2017, SEBI, with the intention of providing ease of access to FPIs, approved certain changes, which included: (1) rationalisation of fit-and-proper criteria for FPIs; (2) simplification of the broad-based requirement for FPIs; (3) discontinuation of requirements for seeking prior approval from SEBI in the event of a change of local custodian or FPI DDP; and (4) permitting reliance on due diligence carried out by the erstwhile DDP at the time of the change of custodian or FPI DDP. In addition, with a view to improve ease of doing business in India, a common application form has been introduced for registration, the opening of a demat account and the issue of a permanent account number for FPIs. Market participants have welcomed all these changes as pragmatic steps by SEBI to enhance the flow of institutional capital into India.

FVCI route

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 through 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 through the FVCI route is that FVCI investments are not subject to the RBI's pricing regulations or the lock-in period prescribed by the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (the ICDR Regulations). Pursuant to the FVCI Regulations, FVCIs must register with SEBI before making investments. The process typically takes 20 to 30 days from the date of application. 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, the 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 required for investment in these sectors.

III THE INSOLVENCY CODE

As predicted, bankruptcy played a huge role in influencing the M&A trends in 2018, with the Insolvency Code being a work in progress and multiple amendments energetically pushed through to strengthen the legal framework for bankruptcy in India. One of the key amendments introduced through the ordinance effective from 6 June 2018 was the reduction in the voting threshold from 75 per cent to 66 per cent of the committee of creditors with respect to key decisions. This change has enabled quick decision-making, allowing for approvals of viable resolution plans. Another welcome amendment was the reduction in the scope of 'connected persons' who are barred from bidding for companies under the Code. Prior to the ordinance, several financial entities having connected persons through investee companies in India or abroad were barred from bidding for companies. The amendment provides a relaxation in respect of these entities, so long as they are not related to the corporate debtor.

The immediate impact of the Insolvency Code is evident from the improvement in India's ranking by the World Bank on the country's ability to handle insolvency cases, moving up 33 places to 103rd position. Also in 2018, the National Company Law Tribunal resolved insolvency cases amounting to more than 800 billion rupees, a figure that is set to hit the trillion-rupee mark as there are several high-profile deals pending. However, the most significant change is the evidence of promoters behaving better in relation to lenders and no longer enjoying an upper hand when negotiating deals with the lenders.

IV SOLICITATION, DISCLOSURE REQUIREMENTS AND FIDUCIARY DUTIES

Typically, investment vehicles issue a private placement memorandum (PPM) or an offer document 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 and risk management tools in Category III AIFs.

A lesson learned last year by the industry from 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 their PPM. Industry experts have criticised the reprimand as misplaced, stating 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 subject to a strict interpretation. Having said that, in accordance with the AIF Regulations, managers and sponsors are beginning to set out the risk of their investments in relation to the minimum amount required to be invested. Since a PPM in India acts as both a marketing and a disclosure document, careful attention has to be paid while drafting the PPM to ensure a fine balance between regulatory requirements prescribed by SEBI and the marketing leverage that they want from their commitments to the fund.

With respect to offshore India-focused funds, the disclosure requirements, marketing guidelines and 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 valuation reports and filing the PPM with SEBI, for domestic funds. Further, there are limitations on the number of investors that an investment vehicle can attract. For instance, no AIF scheme (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 exercise 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 their investors and disclose any potential conflicts of interest.

V TAXATION

i Taxation of foreign funds

As stated earlier, following the adoption of GAAR on 1 April 2017, the Indian tax authorities have the ability to treat arrangements outside India as an 'impermissible avoidance arrangement' if the main purpose of the arrangement is to obtain a tax benefit and the 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 demonstrate commercial reasons for setting up a fund in a particular jurisdiction. The steps that a fund may undertake to demonstrate commercial reasons include the renting of office space, and employment of personnel in that jurisdiction.

The other potential taxation risk in India for offshore funds is the risk of being perceived to have a permanent establishment in India on account of the fund's relationship with the investment advisory team based in India, in which case it would be liable to tax in India. As stated earlier, when determining POEM and actual residency status of an entity, the key guiding principle is whether the entity is engaged in 'active business outside India'. To protect itself from any exposure to charges of having a permanent establishment, a fund must, inter alia, demonstrate that decision-making for the fund is being undertaken at the offshore fund level and not in India. To encourage fund management in India, the Finance Act 2015 provided for safe-harbour rules, where fund management activity carried out through an eligible fund manager in India by an eligible investment fund shall not constitute a business connection in India, subject to the fund and fund manager satisfying various restrictions, such as participation or investment by persons resident in India to be limited to five per cent, and a prohibition on the fund making any investment in its associate entity and carrying on or controlling and managing any business in India or from 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 unitholders. The taxation of Category III AIFs depends on the legal status of the fund (i.e., company, limited liability partnership or trust). Accordingly, investment fund income, other than the business income, is exempt from tax and income received by or accrued to Category I and Category II AIF unitholders is chargeable to tax in the same nature and in the same proportion as if it were income received by or accrued to the unitholder had the investment been made directly by the unitholder. 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 pass-through status to REITs and InvITs. Taxes are imposed on these in the manner set out below:

Particulars SPV REITs Sponsor/investor
Dividend Exempt subject to conditions Exempt Exempt
Interest No withholding Exempt Taxable
Rental income (only applicable for REIT, and not InvIT) No withholding Exempt Taxable
Capital gains N/A Taxable Exempt
Other income N/A Taxable Exempt

Further, tax implications for different streams of income in the hands of the investors are set out below.

Dividends

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 at the rate of 20.55 per cent of the dividend imposed on the distributing company.

Interest

Interest income is subject to tax in the hands of Indian resident investors at the rate that would otherwise apply to the investors on their ordinary income. Income from interest on debt ranges from 5.46 per cent to 43.68 per cent, depending on the regulatory regime, currency of debt and rate of interest.

Capital gains

Any short-term capital gain arising on the transfer of listed shares on any recognised stock exchange in India, where securities transaction tax is payable, is subject to tax at the rate of 15 per cent (plus applicable surcharge and cess) subject to any tax benefit under the relevant tax treaty in the case of both residents and non-residents. Sales off the market that result in short-term gain are subject to tax at the rate of 40 per cent (plus applicable surcharge and cess) subject to any tax benefit under the relevant tax treaty in the case of non-residents and at the rate of 30 per cent (plus applicable surcharge and cess) in the case of residents.

Any long-term gain exceeding 10,000 rupees on transfer of listed shares by both residents and non-residents on any recognised stock exchange in India, where securities transaction tax is payable, is subject to tax at the rate of 10 per cent (without the benefits of indexation and neutralisation of foreign exchange fluctuation) and where the transfer is made after 1 April 2018 and off the market, it is subject to a tax of 10 per cent (without the benefits of indexation and neutralisation of foreign exchange fluctuation).

VI KEY INVESTMENT TERMS

As the alternative investment market in India continues to mature through the involvement of more sophisticated LPs, reporting requirements have become more complex and demanding. Each LP is looking to closely monitor the ways in which the GP is putting the capital to work. Consequently, LPs now include back-office management and reporting as key items on their due diligence checklist when determining which funds to invest in. In addition, reporting requirements have become robust enough to ensure complete visibility of the operating status of portfolio investments.

Over the years, LPs have become much more vocal in their demands for transparency in investment decision-making as well. Accordingly, the nature of the rights of the investment and advisory committees, and seeking a seat on these committees, have become key points of negotiation between LPs and GPs. LPs are also demanding a veto with respect to each investment decision made by the investment committee. In addition, any transaction involving a potential conflict of interest is expected to be referred for resolution to an advisory board consisting of representatives from the LPs.

LPs are also demanding a veto right with respect to critical decisions such as capital deployment, appointment of key personnel, conflicts of interest and sector focus. A positive trend witnessed has been LPs getting involved with the day-to-day operations of the portfolio companies and sharing sectoral expertise to expand the businesses. With many development finance institutions acting as LPs, funds are being compelled to follow international benchmarks with respect to governance, anti-corruption, and environmental and social norms. This increased involvement of LPs in the decision-making process is being driven by a number of factors, such as an unprecedented run-up in sizes, persistent under-performance and unexpected liquidity pressures on LPs.

To attract more LPs, GPs in India are amenable to moving away from the classic '2 and 20' fee–carry model. Since management fees have no bearing on the performance of the portfolio investments, LPs are unwilling to take risks with respect to the percentage of the management fee. When it comes to the amount on which the management fee is being calculated, LPs are demanding that during the commitment period, fees be calculated as a percentage of the capital commitments made to a fund. After the commitment period, the fee should be calculated as a percentage of the capital contribution that has not been returned to the LPs. Further, LPs are opting for co-investment structures, which results in an overall reduction in the fees that LPs pay to GPs. To diversify an LP's risk, waterfalls are being structured to allow 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 assess and set management fees. Further, distribution of carried interest is being structured on a staggered basis such that allocation of carry is proportionate to the returns achieved by the fund.

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 when conducting due diligence checks.

LPs are also expressing concerns about the expenses that are charged to a fund, and are always looking to cap the expenses incurred by GPs, either as a fixed amount or a percentage of the total size of the fund. In the event thatthe LPs and GPs agree to an annual cap on operating expenses, LPs want the right to be consulted before GPs set the annual cap.

With increased scrutiny of the fund structures by tax authorities, GPs have successfully negotiated for clawback clauses from LPs to cover future tax liabilities. While LPs fight to limit the scope of such clauses to a certain fixed period, this may not be acceptable in the Indian context given the long limitation period available to the tax authorities to proceed against funds.

The changing dynamics between LPs and GPs has given both parties an opportunity to remould the Indian private equity space into a more sophisticated market. Practically speaking, perfect alignment of the LPs' and GPs' interests is close to impossible. However, if Indian GPs have to keep the funds flowing from LPs, GPs must get into the habit of making adjustments to the agreed fund terms and conditions.

VII REGULATORY DEVELOPMENTS

i Amendments to FDI conditionalities in e-commerce

The DIPP issued Press Note 2 of 2018 on 26 December 2018 amending the policy regarding FDI in entities engaged in the marketplace model of e-commerce. Formerly, the policy stipulated that the e-commerce entity cannot exercise ownership or control over the inventory (i.e., goods purported to be sold). The amendments went on to clarify that the inventory of a vendor is deemed to be controlled by an e-commerce marketplace entity if more than 25 per cent of the vendor's purchases are from the marketplace entity or its group companies. Further, the amendment lays down a restriction on an entity having equity participation by an e-commerce marketplace entity or its group companies; or on an entity having an e-commerce marketplace entity or its group companies control the entity's inventory to sell the entity's products on the platform run by the e-commerce marketplace entity. While the changes have been brought in to appease domestic brick-and-mortar businesses, the amendments are definitely a big blow to e-commerce retailers such as Amazon and Flipkart. Having said that, all market participants have sought clarity on certain interpretational issues to ensure their businesses are compliant with the restrictions.

ii Constitution of the National Financial Reporting Authority

The year 2018 also witnessed a string of corporate frauds that raised concerns among investors in relation to corporate governance and credit worthiness of portfolio companies. As an immediate response, the government approved the establishment of the National Financial Reporting Authority (NFRA) as an independent regulator for the auditing profession under Section 132 of the Companies Act 2013. The jurisdiction of the NFRA will extend to listed companies and large unlisted public companies, and it will have the power to monitor and enforce compliance of accounting and auditing standards. It is supposed to oversee the quality of service and undertake investigation of the auditors of listed entities. If during investigation the NFRA finds non-compliance with the Companies Act 2013 involving fraud amounting to 10 million rupees or more, it shall report its findings to the central government. The move is being heralded as a step in the correct direction towards preserving the credibility of India as a safe destination for investments.

iii REITS and InvITs

In 2018, SEBI amended the guidelines for public issue of units of REITs and InvITs with a view to further rationalising and easing the issuing process. The amendments include allocation to anchor investors to be on a discretionary basis and subject to a minimum of two investors for allocations of up to 2.5 billion rupees, a minimum of five investors for allocations of more than 2.5 billion rupees, and alignment of the definition of institutional investors with the definition in the ICDR Regulations. The duration of the period for announcement of a price band or floor price by the manager of a REIT or InvIT under Clause 8(3) has been reduced from five working days to at least two working days prior to the opening of the bid. The bidding process under Clause 9 has been modified to provide for acceptance of bids using the Applications Supported by Blocked Amount facility for making payment, facilitated through electronic bidding platforms to be provided by recognised stock exchanges. On 25 January 2019, SEBI released a consultation paper in relation to further amendments to the regulations governing InvITs, on relaxing trading rules. If the amendments are implemented, the minimum subscription amount for an investor in an initial public offering and follow-on offer of an InvIT will be reduced to a range of 15,000 to 20,000. After initial listing, the trading lot should also be in multiples of 100 units. This proposal indicates a move by SEBI to include retail investors within the ambit of the InvIT investor community.

iv Operating guidelines for AIFs in IFSC

In November 2018, SEBI prescribed detailed operating guidelines to regulate AIFs in India's first International Financial Services Centre (IFSC) set up under Section 18(1) of the Special Economic Zones Act 2005 in Gujarat International Finance Tec-City, Gujarat. This is in furtherance of the guidelines prescribed in 2015 to facilitate and regulate the securities market at the IFSC. The operating guidelines allow AIFs in the IFSC to invest through the FVCI, the FDI or the FPI routes. Previously, AIFs in the IFSC were allowed to invest only through the FPI route. In addition, the caps applicable to AIFs (see Section II.iv) will not be applicable to an AIF set up in the IFSC. The guidelines provide global investors a more viable option to set up global funds in the IFSC in the form of an AIF.

v Integrated online reporting of foreign investments in India

To simplify the reporting process of foreign investments, the RBI released the Single Master Form (SMF) with effect from 1 September 2018. With the implementation of the SMF, the reporting of FDI, which is presently a two-step procedure, namely ARF and FC-GPR, is merged into a single revised FC-GPR. At present five forms, FC-GPR, FC-TRS, LLP-I, LLP-II and CN, are being made available for filing using the SMF. With effect from 1 September 2018, all new filings for these five form categories have to be done using the SMF only.

VIII OUTLOOK

In 2018, record-breaking M&A and fundraising activity were witnessed owing to myriad factors, including the enactment of the Bankruptcy Code, simplification of the regulatory regime and further liberalisation of the FDI regime. With deal activity in 2018 having set the bar particularly high, the first few months of 2019 should see investors treading cautiously on account of both political uncertainty in India (at least until the lead-up to the general elections in India) and global uncertainty, with events such as Brexit having an impact on emerging markets such as India. Having said that, there is a tacit acknowledgment among global PE investors that India continues to have a huge appetite for foreign investments, with no comparable level of opportunity worldwide. Strong macro drivers, such as strong demographics, a burgeoning consumer segment and policies promoting a favourable business environment, are expected to keep investors focused on the Indian market in 2019.

From a sector perspective, we expect investors to show interest in e-commerce, financial services, healthcare and logistics. The coming years will witness many more buyouts or control transactions, including large corporate carve-outs and family businesses exploring exits; this would also involve family-run businesses proactively seeking value addition from global private equity firms to help scale up their businesses.


Footnotes

1 Raghubir Menon and Ekta Gupta are partners and Deepa Rekha and Srishti Maheshwari are senior associates at Shardul Amarchand Mangaldas & Co.

62 An AIF that invests in start-up or early stage ventures or social ventures or small and medium-sized enterprises or in infrastructure or other sectors or areas that the government or regulators consider 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).

63 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.

64 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 making short-term returns or other open-ended funds can be included.