Private equity: investing in India (2024)

This article is an extract from Lexology In-Depth: Private Equity - Edition 13. Click here for the full guide.

I Introduction

i Deal activity

In 2023, 1,641 deals with an aggregate value of US$65.90 billion were reported, indicating a sharp decline of 52 per cent in deal value and 21 per cent in deal volume compared with the previous year. That said, the levels of both the deal value and the deal volume remained consistent with what has been seen during the past decade, apart from 2022.² Domestic consolidations during 2023 included 350 deals valued at US$14.4 billion, at an 80 per cent decline from 2022 in value.

Table 1: Dealmaking activity – comparing 2023 with 20223

Deal making activity: mergers and acquisitions

A total of 494 merger and acquisition (M&A) deals valued at approximately US$25.20 billion were reported in 2023, reflecting a 3 per cent increase in deal volume but a staggering 72 per cent decline in values against the previous year.⁴ Of the top 10 M&A deals by value in 2023, only four were valued at more than US$1 billion and no deal exceeded US$2.5 billion. In contrast, three marquee deals in 2022 were valued at more than US$10 billion each. The decline in deal value is attributable to the absence of such deals in 2023. It is significant to note that if the merger of Housing Development Finance Corporation Limited (HDFC) with HDFC Bank Limited (valued at US$40 billion)⁵ is excluded from the year-on-year comparison, the dip in aggregate deal value is less steep. As set out above, on a longer timeline, both the deal value and deal volume in 2023 remained largely consistent with levels seen during the past decade, excluding 2022.⁶

In addition, of the top 10 M&A deals in 2023 (which accounted for 44 per cent of the aggregate value of all M&A deals), four deals involved the acquisition of a 100 per cent stake in the target, three deals involved the acquisition of a majority or controlling stake in the target, two deals involved the acquisition of a minority stake in the target and one deal involved a merger of companies.⁷

Dealmaking activity: private equity

A total of 1,045 private equity (PE) deals valued at US$27.40 billion were recorded in 2023, indicating a decrease in both deal volume and deal value.⁸ This decline can be attributed to the headwinds faced by PE and venture capital (VC) investments on account of inflation, the rising cost of capital, fears of a recession and rising geopolitical tensions, which have led to an expectations gap between buyers and sellers and resulted in a bid-ask spread, which, for a significant part of 2023, was the primary cause behind the fall in transaction closures.⁹ In addition, unicorn status was accorded to only two start-ups in 2023 – Zepto and InCred Financial Services Limited¹⁰ – compared with the 20 that emerged in 2022.

Although the buoyant capital markets have proved to be a negative for private transactions on account of the valuation mismatch between investors and sellers, they have been a tailwind to PE/VC exits, which recorded a healthy growth of 36 per cent, making 2023 the second-best year for PE/VC exits at US$24.8 billion. Exits via open market reached an all-time high of US$12.8 billion (achieved through initial public offerings (IPOs) or follow-on stake sales in recently listed PE-backed companies).¹¹

Key sponsors in the Indian market

Both domestic institutional investors (DII) and foreign intuitional investors (FII) have deployed a large amount of capital within the Indian markets during the past decade. After sustained buying at the beginning of 2023, FIIs turned net sellers towards the end of the second quarter, pulling out approximately US$2 billion as rising US bond yields and crude prices weighed on market sentiment.¹² In November, however, the outflow on account of FII exits notably eased as a result of lower US bond yields and a decline in crude oil prices, and has been offset considerably by DII purchasing.¹³ Some key DIIs and FIIs, in terms of dealmaking activity in 2023, include Temasek, Abu Dhabi Investment Authority, Walmart Inc and Qatar Investment Authority. In an unexpected move, the Omidyar Group, which has channelled approximately US$0.5 billion in investments in India since 2010, has announced it will completely exit the Indian market in 2024.¹⁴

ii Operation of the market

Equity incentive arrangements

The structure and terms of equity incentives are key considerations for PE sponsors to ensure alignment of interests and value creation for all participants. Common themes for equity incentive arrangements in India include the following.

Employee stock option plan

Under the conventional employee stock option plan (ESOP), a company typically sets up a trust to administer the ESOP scheme. Employees are given the option to purchase shares, which are generally locked in for a certain period, non-transferable and cannot be pledged, hypothecated or encumbered, and the option can be exercised after vesting in the employees. Usually, the share option plan is structured in such a way that shares will vest in tranches,¹⁵ which may be arranged to align with a period covering the anticipated duration of the PE investment. In light of the funding winter in 2023, the number of ESOP cash-out events by start-ups fell by more than 62 per cent to 16 in 2023 from 42 in 2022.¹⁶

Employee stock purchase plan

Under an employee stock purchase plan, shares in the company are allotted up front to an employee, either at a discount or at par, without any vesting schedule. In addition, the law also permits the issuance of sweat equity shares (at a discount or for consideration other than cash) to management or employees for their know-how, intellectual property or other value added to the company.

Stock appreciation rights plans

Stock appreciation rights plans (SARs) entitle an employee to receive the appreciation (increase of value) for a specific number of shares in a company where the settlement of the appreciation may be made by way of either a cash payment or shares in the company. SARs settled by way of shares are referred to as equity-settled SARs. 'Phantom stock options' or 'shadow stock options', a popular nomenclature derived from usage for SARs, is a performance-based incentive plan that entitles an employee to receive cash payments after a specific period or on fulfilment of specific criteria, and is directly linked to the valuation and the appreciated value of the share price of the company.¹⁷

Other management equity incentives

Other management equity incentives may also be structured through issuances of different classes of shares or management upside agreements (also called earn-out structures or incentive fee arrangements). Earn-out agreements are typically cash or equity settled agreements entered into between an investor and founders or key employees of a company, with the understanding that if the investor makes a profit on its investment at the time of its exit, a certain portion of the profit will be shared with those individuals. While giving investors a measure of control regarding the terms of an exit, earn-out agreements are also devised to incentivise and retain employees for a determined period. Typically, as the company is not a party to the agreement, the compensation is not charged to or recoverable from the company itself, and these transactions are not reported within the ambit of related-party transactions entered into by the company. The policy argument against upside sharing agreements is rooted in the possible conflict of interests between promoters and the management team in relation to the company and its other shareholders.¹⁸ In recent years, Indian companies and other stakeholders have continued to explore upside sharing structures.

Standard sales process

Dealmaking in India traditionally has remained relationship-driven, involving identifying the target with high-quality assets from a shallow pool of assets in the market, winning deals, establishing synergy with the founders, promoter groups or management, agreeing on indicative valuation and entering into a term sheet.

In the past few years, however, there has been a paradigm shift towards a controlled competitive bid model run by investment bankers or similar intermediaries. A seller-led trade sale process by way of a controlled auction has the following advantages:

1. bringing more potential buyers into the sale process;
2. creating competition among bidders, thereby encouraging higher prices and more favourable terms for the seller (including diluted warranty and indemnity packages);
3. satisfaction of corporate governance concerns by maintaining transparency of process and superior control over the flow of information and securing the highest reasonably attainable price for stockholders;
4. the ability to shorten the timelines by creating deadlines for submission of bids and completing various phases of the sale process; and
5. a greater degree of confidentiality.

In addition, controlled bid processes have the potential to unlock value and have fetched astronomically high valuations for highly desirable assets that were put on the block, thus making an auction sale an attractive option for the selling stakeholders.

In recent years, emerging trends in sale processes in India have included:

1. institutional sellers not providing any business warranties except in buyouts or control deals;
2. parties using escrow mechanisms and deferred consideration for post-closing valuation adjustments and indemnities;
3. target management facilitating trade sales and providing business warranties under contractual obligations under shareholders' agreements or on account of receiving management upside sharing incentives;
4. use of locked-box mechanisms; and
5. buyers arranging warranty and indemnity insurance to top up the diluted warranty and indemnity package obtained in competitive bid situations to ensure that meaningful protection is obtained.

II Year in review

i Recent deal activity

The focus in 2023 appeared to be on strategic, cost-effective transactions, rather than immediate cash-intensive ones, as evidenced by the emerging trend of conglomerates and high-value investor groups acquiring smaller companies to boost their assets and market presence. Notably, domestic deals contributed 27 per cent to the volume and 23 per cent of the overall value of the M&A deals entered into in 2023,¹⁹ and also accounted for some of the largest M&A deals of the year.

In terms of sectoral activity, there has been a well-distributed diversification across major sectors, such as e-commerce, healthcare and real estate, and deal value in the pharmaceutical, manufacturing and information technology (IT) sectors has increased from the previous year.²⁰

Table 2: Top five M&A deals in 202321

The start-up ecosystem in India, which is ranked third globally, had another dry year in 2023.²³ PE deals decreased in volume by 32 per cent and in value by 23 per cent from the previous year, with the start-up, e-commerce and IT sectors leading by volume and the pharmaceutical, e-commerce and energy sectors leading by deal value. The funding winter has continued into 2024.²⁴

Table 3: Top 5 PE deals in 2023

ii Financing

Acquisition financing in India is constantly evolving to adapt to the strict regulatory framework and restrictions imposed by the Reserve Bank of India (RBI).²⁵ Typically acquisition financing in India is funded by:

1. Foreign portfolio investors (FPIs);
2. non-banking financial companies (NBFCs);
3. subscription to securities by Indian entities;
4. registered onshore alternative investment fund; and
5. international banks, institutional lenders, funds and other entities.²⁶

Indian exchange control regulations prohibit Indian parties from pledging their shares in favour of overseas lenders if end use of the borrowing is for any direct or indirect investment in India.²⁷ Indian companies that are foreign owned or controlled are prohibited from raising any debt from the Indian market to make any further downstream investments.²⁸

In addition, Indian entities are not permitted to raise external commercial borrowings (ECBs) for the purposes of acquisition of shares, and the Companies Act, 2013 restricts public companies (including deemed public companies) from providing direct or indirect security or financial assistance for the acquisition of their own securities. Mezzanine finance is generally raised in the form of compulsorily convertible preference shares, optionally or partially convertible preference shares, compulsorily convertible debentures or optionally or partially convertible debentures.²⁹ However, if the mezzanine finance is provided by an offshore entity, optionally or partially convertible preference shares or optionally convertible debentures are treated as ECBs and will need to comply with the applicable guidelines.³⁰

Indian masala bonds, which may be issued to overseas lenders, have emerged as another option for debt financing; however, PE investors are reluctant to use these to finance domestic acquisitions, as there is a prevailing view that proceeds raised through the issuance of masala bonds cannot be used for capital markets and domestic equity investments.³¹ Although banks in India are prohibited from issuing payment-in-kind loans, they can be obtained through NBFCs or structured through non-convertible debentures.³²

iii Key terms of recent control transactions

PE investors have recently shown a preference for acquisition of controlling stakes, with six of the top 10 M&A deals in 2023 involving the acquisition of a majority or 100 per cent stake.³³ With US$6.4 billion in buyout activity at 39 per cent of PE deal value within the first six months,³⁴ 2023 surpassed the buyout activity of 2022, during which PE funds sealed a total of 36 control and buyout deals with a total announced value of US$7.65 billion across 28 deals.³⁵ This represents a decline from 2021, which was an exceptional year, recording 42 buyout deals worth US$17.4 billion.³⁶ However, steered by the need for value creation, preservation and enhancement, control will remain a key element for most investors in future, as it has become a deal driver in most transactions.

Pursuant to the acquisition of a controlling stake, the PE investor will either hire a fresh management team or choose to retain the existing management team. As an emerging trend, PE firms are choosing to engage dedicated operating teams, hire industry leaders with sectoral expertise or engage external consultants. Typically, control deals in India include terms around deferment of consideration and post-closing adjustments, to provide suitable comfort to the acquirer for any post-valuation or completion expenditure or liabilities. In addition, essential pre-completion requirements for giving effect to control transactions include obtaining third-party lender consents, consents for change of control (if applicable) under key agreements, and consents from sectoral regulators, which are essential for ensuring post-acquisition business continuity.

iv Exits

There was a 36 per cent growth in PE exits in 2023, with 303 exits valued at US$24.8 billion compared with 248 exits in 2022 valued at US$18.3 billion.³⁷ That said, this represents a 37 per cent decline in exit value compared with 2021, when exits totalled US$39.6 billion in value.³⁸ In 2023, open market exits accounted for US$12.8 billion recorded across 131 deals – a growth of 94 per cent from the previous year and a peak of 30 PE-backed IPOs – whereas strategic exits and buybacks recorded declines of 33 per cent and 13 per cent, respectively, from 2022 levels.³⁹ From a sectoral perspective, the financial services sector had the highest value of exits in 2023 (US$7.4 billion across 80 deals), followed by the e-commerce sector (US$2.9 billion across 35 deals) and healthcare (US$2.8 billion across 16 deals).⁴⁰

Table 4: Largest PE exits in 202341

III Legal framework

i Acquisition of control and minority interests

Key deal structures

Acquisition in India can be structured by way of merger or demerger, as an asset or business transfer, as a share acquisition or joint venture. Commercial and tax advantages are key considerations for investors when determining the structure for the transaction.

Legal framework

The principal legislation governing share purchases, slump sales, asset and business transfers, joint ventures, and liquidation and insolvency is the Companies Act, the Indian Contract Act, 1872, the Specific Relief Act, 1963, the Income Tax Act, 1961, the Competition Act, 2002 and the Insolvency and Bankruptcy Code, 2016.

Competition is regulated by the Competition Commission of India (CCI), which has to pre-approve all PE transactions that fall above the thresholds prescribed in the Competition Act. When evaluating an acquisition, the CCI mainly scrutinises whether the acquisition will lead to a dominant market position and affect competition in the relevant market. In addition, transactions involving listed entities or public money are also governed by various regulations promulgated by the securities market regulator (the Securities and Exchange Board of India (SEBI)), and the Banking Regulation Act 1949 specifically governs the functioning of banks and NBFCs under the supervision of the RBI. Relevant foreign exchange laws (including the Foreign Exchange Management Act, 1999 (FEMA), and the rules and regulations framed under it, apply in any cross-border investment involving a non-resident entity.

Furthermore, there is sector-specific and subject matter-specific legislation, including legislation that is applicable to environmental, intellectual property, employment and labour matters, that may be applicable to a transaction. A key piece of legislation in finalising deal dynamics is the Indian Stamp Act, 1899, which provides for stamp duty on various instruments, including transfer of shares, conveyances and definitive documents.

Structuring and entry routes for offshore investors

Foreign investment is permitted in a company and limited liability partnership subject to compliance with sectoral caps and conditions. However, foreign investment is not permitted in a trust, unless the trust is registered with SEBI as a VC fund, alternative investment fund, real estate investment trust (REIT) or infrastructure investment trust (InvIT). Foreign PE investors can invest in India through the following entry routes.

Foreign direct investment

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 is made by way of subscription or purchase of securities, subject to compliance with the pricing guidelines, sectoral caps and certain industry-specific conditions. FDIs are governed by the rules and regulations set out under the FDI policy and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the NDI Rules).

Foreign portfolio investment

Foreign portfolio investors (FPIs) in India are governed by the SEBI (Foreign Portfolio Investors) Regulations, 2019.⁴² FPIs are permitted to invest in shares, compulsorily convertible debentures, warrants and other permissible instruments listed, or to be listed on a recognised stock exchange in India (through both primary and secondary routes), subject to the aggregate holding by the FPI of the total paid-up equity capital (on a fully diluted basis) or the paid-up value of each series of debentures, preference shares or warrants issued by the investee company not exceeding 10 per cent. If this threshold is breached, the investment is reclassified as FDI, in the manner specified by SEBI and the RBI. Foreign investors who have a short investment horizon and are not keen on engaging in the day-to-day operations of the target, or want to invest through debt securities without the investment being classified as an ECB, may opt for this route after prior registration with a designated depository participant as an FPI. The process of registration is fairly simple and ordinarily it does not take more than 30 days to obtain the certificate.

Foreign venture capital investment

The foreign venture capital investor (FVCI) route was introduced with the objective of allowing foreign investors to make investments in VC undertakings. Investment by such entities into listed Indian companies is also permitted subject to certain limits or conditions. Investment through this route requires prior registration with SEBI under the SEBI (Foreign Venture Capital Investors) Regulations 2000.⁴³ Investment companies, trusts and partnerships, mutual funds, charitable institutions, asset management companies, investment managers and other entities incorporated outside India are all eligible for registration as FVCIs. One of the primary benefits of investing through this route is that FVCI investments are not subject to the RBI's pricing regulations or the lock-in period (after listing of shares). The NDI Rules also allow FVCIs to purchase equity, equity-linked instruments or debt instruments issued by Indian start-ups, irrespective of the sector, subject to compliance with the sector-specific conditions (as applicable).

Tax structuring for offshore investors

Double taxation avoidance treaty

The tax treatment accorded to non-residents under the Income Tax Act, 1961 is subject to relief as available under the relevant tax treaty between India and the investor's country of residence. If the non-resident is based in a jurisdiction that has entered into a double taxation agreement (DTA) with India, the double taxation implications are nullified and the Indian income tax laws apply only to the extent that they are more beneficial than the terms of the DTA, subject to certain conditions. PE investors structure investment through an offshore parent company with one or more Indian operating assets. Understandably, the primary driver that determines the choice of jurisdiction for an offshore investing vehicle is one of approximately 90 jurisdictions that have executed a DTA with India.

General Anti-Avoidance Rule

To curb tax avoidance, the Indian government introduced the General Anti-Avoidance Rule (GAAR) with effect from 1 April 2017, with provision for any income from the transfer of investments made before 1 April 2017 to be grandfathered. It is now imperative to demonstrate that there is a commercial reason, other than to obtain a tax advantage, for structuring investments out of tax havens. Once a transaction falls foul of the GAAR, the Indian tax authorities have been given wide powers to disregard entities in a structure, reallocate income and expenditure between parties to the arrangement, alter the tax residence of the entities and the legal situs of assets involved, treat debt as equity, and vice versa, and deny DTA benefits.

Place of effective management risk

Under the Income Tax Act, 1961, tax residence forms the basis of determination of tax liability in India, and a foreign company is to be treated as tax resident if its place of effective management (POEM) is in India. Pursuant to the POEM Guidelines, POEM is 'a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are in substance made'. If a foreign company is regarded to have a POEM in India, its global income is taxable in India at the rates applicable to a foreign company in India (at an approximate effective rate of between 41.2 and 43.26 per cent). Accordingly, PE investors must exercise caution when setting up their fund management structures, and in some cases their investments, in Indian companies.

ii Fiduciary duties and liabilities

Under Section 166 of the Companies Act, and according to various rulings of courts in India, it is well established that any directors appointed to the board of a company, including those nominated by shareholders, are obliged (1) to act in good faith for the benefit of its members as a whole and in the interests of the company, employees, shareholders, community and the environment, (2) to act with due and reasonable skill, care and diligence and exercise independent judgement, (3) not to be involved in a situation that may lead to a direct or indirect conflict or possible conflict of interests with the company, and (4) not to achieve or attempt to achieve any undue gain or advantage either for themselves or for their relatives, partners or associates.

To mitigate the risk associated with a nominee director facing liability on account of any issues arising out of the day-to-day management and operations of the target company, PE investors should appoint their nominees as non-executive directors and specifically designate the officer responsible for ensuring statutory and operational compliance. In addition, the shareholders' agreements entered into by PE investors should include an obligation for the company to obtain adequate directors' and officers' liability insurance coverage for its nominee.

PE investors, as shareholders in target companies, do not have any additional fiduciary duties or any restrictions on exit or consideration payable for a fund domiciled in a different jurisdiction (from a fiduciary duty or liability standpoint). The inter se contractual rights between shareholders and the company shall be governed by the respective shareholders' agreements. In a control deal, however, for certain regulatory purposes, a majority investor may be viewed as a promoter and be subject to more stringent duties towards the shareholders of the company.

In addition, REITs and InvITs in India that are governed by applicable SEBI regulations, provide for the concept of a 'sponsor', which is the designated person or entity that establishes the REIT or InvIT, and the sponsor group means the sponsor, and any entity or persons controlling or controlled by the sponsor. In a recent bid to protect the interests of investors, SEBI has prescribed regulated lock-in periods for sponsors and sponsor groups.

Furthermore, SEBI has set out guidelines in the form of a stewardship code for unitholders holding at least 10 per cent of the total outstanding units of the REIT or InvIT. The stewardship code requires sponsors, inter alia, to act in the best interests of the REIT or InvIT, to formulate a comprehensive policy on the discharge of their stewardship responsibilities, to implement a policy to manage points of conflict of interest and to implement a policy on voting.

IV Regulation

Relevant regulatory bodies

In the context of PE investments, the relevant regulatory bodies in India are the RBI, SEBI, the CCI, the Department for Promotion of Industry and Internal trade and other sectoral regulators, depending on the sector in which the PE investor makes an investment, such as the Insurance Regulatory Development Authority, the Telecom Regulatory Authority of India and the Directorate General of Civil Aviation.

Competition Commission of India

The CCI is the primary regulator for promoting sustainable competition in India. Approval from the CCI is necessary when a transaction crosses the thresholds set across in the Competition Act, 2002.

Department for Promotion of Industry and Internal trade and other government ministries governing FDI

The FDI policy in India and the FEMA provide two routes for foreign investment in India: the automatic route and the government route. For the latter, prior government approval is necessary. The regulations currently specify sector-specific thresholds and country-specific restrictions under which each transaction may fall and, accordingly, need prior approval from the government.

Securities and Exchange Board of India

SEBI is the primary securities regulator in India and looks after all approvals necessary in relation to the purchase, sale and transfer of securities in Indian markets, including acquisitions by foreign and domestic companies under the takeover regulations, trading on the stock market and IPOs by companies.

V Outlook and conclusions

In a year plagued by multiple geopolitical conflicts, interest rate increases by several governments and a sluggish global economy, India's gross domestic product (GDP) in the 2022–2023 fiscal year grew at a rate of 7.8 per cent in the first quarter and at 7.6 per cent in the second quarter.⁴⁴ This is an uptick from the growth rate of 7.2 per cent in the 2022–2023 fiscal year, which was the second highest among G20 countries and almost twice the average for emerging market economies, firmly placing India as one of the fastest-growing major economies in the world.⁴⁵ Overall, the Indian economy appears to be on track to perform according to the estimates released by the National Statistical Office, which project that the real GDP during the 2023–2024 fiscal year will be 7.3 per cent,⁴⁶ outperforming the projections of both the International Monetary Fund and the RBI. That said, there is the possibility of a slowdown and there is uncertainty about the outlook owing to factors such as inflation, the still-present threat of emerging coronavirus variants, supply chain disruptions and spikes in energy and commodity prices on account of geopolitical issues.⁴⁷

It is likely that the forthcoming general elections and the predictions of a conservative interim budget have held back market players from making significant moves in 2023.⁴⁸ Although macro impediments are likely to continue to represent meaningful – albeit waning – headwinds for investors in India, the coming quarters are also likely to yield tremendous opportunities for firms with diversified platforms, flexible approaches, and the depth of experience required to capitalise on an investment landscape like the Indian economy,⁴⁹ which is touted to enter a 'Goldilocks period',⁵⁰ resulting in an optimistic outlook for dealmaking activity in the coming year.