Are legal hassles holding back PE funds in India?

By Menaka Doshi and Isha Dalal, CNBC-TV18:

World over, private equity investments are treated differently from strategic investments. Rules are framed especially for such financial investors but that’s not the case in India. There has been flood of PE deals these past 3-4 years. From deals worth almost USD 8 billion dollars in 2006 to USD 19 billion of deals last year and about USD 4 billion already done this year.

The big deal is that many more private equity investors would have come to India and invested bigger bulks, if only we got the rules right.

India’s largest law firm Amarchand Mangaldas counts many leading private equity firms amongst its clients. The last few years have been M&A boom time and firm leader Cyril Shorff has no reason to complain. But the expert lawyer in him points out that private equity deals need more favourable regulations to truly thrive.

Cyril Shroff, Managing Partner, Amarchand Mangaldas says, "You cannot treat purely financial investors on the same bases as you would treat strategic investors as there is a conceptual flaw there."

Rajiv Sahney, NV Advisory Services says, "The issue right now is not that I think that private equity is being penalized but it is much more that private equity’s needs are not really being addressed."

Avnish Bajaj, Matrix Capital Partners adds, "Overall our business model works if we are able to maximise our profits and cut our losses. Maximisation of profits is not as much of an issue in India because if you list, the company is doing well, there is no issue. But there are a lot of laws which make it difficult for us to cut our losses."

So what are the key issues holding back private equity funds?

The first one is Governance Rights - private equity investors hope to have a say in a company’s fundamental issues. For example, amendments to the company’s articles of association. A fresh issue of shares, a change in the company’s business activities or dissolution or winding up of the company.

Bajaj says, "We want to be able to influence the course of some of the decisions but it is not legally a right we have."

And that’s because the takeover code interrupts such governance or veto rights as control and that could force the investor to make an open offer.

Shroff elaborates - "Control is not defined very precisely, it is a very broad definition. It is not merely positive control as in 51% but it also includes negative control and the interpretation is that even the negative control in the form of board seat accompanied by veto rights, would constitute negative control."

Sahney says, "The government needs to be very clear as to what role they are seeing private equity play. Are they seeing it as being a part of the promoter group or are they seeing it as an investment objective. If they seeing it as an investment objective, there needs great clarity as to what an investor’s rights are and those should not be clubbed with promoter’s rights."

But that’s not all. Now there is new problem - share reclassification. Shares and convertible debentures are a standard issue but private equity firms prefer investing via optionally convertible preference shares. This even though Optionally Convertible Preference Shares India offer limited dividends, no voting power and have a 18 month time limit for conversion.

Bajaj says, "It is an instrument that has been popularized worldwide because it gives the right level of risk-reward. You are able to pull your money out at face value, which is why it looks a little bit like debt or if the company is doing well, one can ride the upside on the equity. It is really a negotiation between the company or the promoters and the investor, so I am not so sure why the regulatory aspect has to come in there."

Dalal adds, "But since May 2007, optionally convertible preference shares happened classified as debt which means that any PE investment through them has to conform with the ECB norms and get RBI approval. So is there a way out? Yes, the compulsory convertible shares with voting on an as-if converted basis. Except that these shares may require FIPB approval."

Vishal Gandhi says, "The funds that we have been working with prefer to use instruments that can allow them to invest under the automatic route, which typically - government approvals - take time and therefore they want to use instruments that can quickly close the transaction. So what they do is they subscribe to a mix of equity and preference shares. They would subscribe to one equity share with disproportionate voting rights and then they would subscribe to preference shares so that they are protected are protected in terms of preferential dividends and preferential liquidation in preferences and all of that. That is what they have been doing. But there are risks attached to that."

Talking about risk, try investing in a falling market. You may think that lower valuations make this an ideal time for investment. Thing again. SEBIs minimum pricing guidelines mean that investments must be priced at the six-week daily average or the 26-week weekly average.

Shroff says, "You have this anomalous situation where the floor price is significantly higher than what is justified in today’s market conditions."

But if getting in seems tough, they try getting out. Foreign private equity firms cannot really sell preference shares because the RBI classifies the sales proceeds as dividends. And that comes with a cap. Also, RBIs pricing formula means that this sale takes place at a high price. It is equally tough for a private equity investor to sell stake back to the company, especially in the case of early stage companies. That is because the buyback of shares must be from the companies’ accumulated profits, which aren’t tough to come by at that stage.

These problems remind Avnish Bajaj of 2000, when he had just started bazee.com with nine investors. Some of which wanted to exit after the dotcom crash. But it wasn’t so easy.

Bajaj says, "These issues started surfacing then as well that even if I want to make sure that this investor is able to exit - he is ready to take a loss but he wants to exit and this I am talking about in a downside scenario - the company law makes it very difficult to for that to be done."

But that is not all. Insider trading norms prevent private equity funds from doing special due diligence for a listed company. And then there is a lack of debt market to make buyout funding accessible. Even then India attracted USD 19 billion in private equity investments last year. Just imagine if the rules were cleaned up.