Private Equity

In India, an abundance of legislative provisions at the federal, provincial and municipal levels intermesh and have relevance in the private equity context. The key statutes dealing with domestic, foreign and cross-border private equity investments include the following:

• The Companies Act, 2013, and the rules, regulations, directions and other circulars issued thereunder, govern the conditions and procedures relating to companies in general including issuance and transfers of shares and other securities.
• The Income Tax Act, 1961 governs all aspects related to direct taxation, including private equity transactions. The Income Tax Act stipulates the taxes applicable to income, capital gains, tax benefits, exemptions from tax liability and methods to determine the valuation of shares and other securities. The act may be limited in its applicability to a particular case in view of any applicable double taxation avoidance treaty or agreement involving India.
• The Foreign Exchange Management Act, 1999 (FEMA), and the rules, regulations, circulars and guidelines issued thereunder, enables India’s central bank, the Reserve Bank of India (RBI), to monitor and regulate inflow and outflow of foreign moneys into and from India, including with respect to all foreign investments. The RBI sits at the head of the Indian banking system and coordinates closely with the government, as necessary, in its operations.
• The Consolidated Foreign Direct Investment Policy is issued and amended from time to time by the Department for Promotion of Industry and Internal Trade (DPIIT), along with subordinate delegated legislation such as rules, directions, regulations and guidelines issued either by the government or by the RBI, pursuant to FEMA, in particular regulating foreign direct investment (FDI) into India. The latest consolidated FDI Policy, which is currently in force, was released by the DPIIT on 15 October 2020.
• India’s securities market watchdog, the Securities Exchange Board of India (SEBI), governs the regulatory aspects of private equity investments in listed entities by issuing regulations on various critical aspects, such as:
• • the issue of capital and disclosures;
  • the acquisition of shares and takeovers;
  • alternative investment funds; and
  • insider trading.
• SEBI’s regulatory powers over alternative investment funds (AIFs) impacts on their ability to invest in non-listed entities. To that extent, SEBI has a regulatory role to play even in investments in private companies in India which are made by AIFs.
• Due diligence (review and analysis processes) is typically conducted prior to the conclusion of private equity transactions. This involves extensive legal review of the status of the target’s compliance with applicable law, including any sector-specific legal requirements and compliance.

In the mid-1990s, after the liberalisation of the Indian economy, the private equity market saw smaller investments in technology-oriented companies. However, the investment scenario has changed dramatically since the start of the 21st century, as different investment structures are used across various industries. Today, the Indian private equity market has evolved into a larger, more mature and organised market with a wide range of investment targets – almost akin to the structures typically found in developed markets around the world.

There are three specific positive factors that are of particular relevance and appeal in the Indian private equity market:

• India – much like the rest of the Anglo-Saxon world – is a common law jurisdiction, encapsulating legal principles that are largely similar to, and incorporating key regulatory and enforcement structures found in, the United Kingdom and the United States. Familiarity with legal foundations and principles is therefore a key facet of the Indian legal system when viewed from overseas.
• The Indian legal system is based on the principle of freedom of contract, coupled with the principle of due and proper enforcement of contractual provisions freely entered in accordance with the relevant laws. This makes it easier for foreign investors to understand, enter, navigate and exit the Indian market on the basis of mutually agreed contractual understandings. Although India’s legendary bureaucracy and systemic corruption can be real dissuading factors, recent governmental and systemic intervention (including by the Indian courts) has militated against such negative effects – albeit perhaps less than the ideal.
• In the three decades since the liberalisation of the Indian economy, the regulatory authorities have introduced and developed meticulous procedures and rules to govern different types of private equity transactions. As a result, Indian companies and overseas private equity investors have benefited from growing certainty and increasing exactitude in the regulatory environment. Additionally, the increased regulatory relaxations and incentives afforded to certain entities, depending on their scale and capital, have further incentivised both investors and target entities, boosting and encouraging investments as a result. These include incentives for start-ups under the Companies Act and schemes introduced by the government to attract and appeal to private equity investors.

Private equity transactions in India are primarily governed by the Companies Act and the Foreign Exchange Management Act (FEMA), India’s foreign exchange law, to the extent that a foreign investor is involved. The Companies Act is governed and administered by the Ministry of Corporate Affairs (MCA); while FEMA is largely governed and administered by the Reserve Bank of India (RBI), India’s central bank. In the case of listed entities and related investments and exits, the Securities Exchange Board of India (SEBI) regulates the landscape.

The powers of the Indian regulators are summarised briefly below.

Ministry of Corporate Affairs: The MCA administers the Companies Act and is responsible for regulatory oversight and management of various forms and filings required to be completed and reported by Indian bodies corporate. All forms and filings are regulated by the MCA in relation to the incorporation of a company, the conduct of a company and fundraising through private equity. They must be submitted to the Registrar of Companies (RoC) within whose local jurisdiction the company falls.

When fundraising through private equity, private companies must file various documents and forms with the RoC, including:

• Form PAS-3 (return of allotment); and
• Form MGT-14 (filing of resolutions and/or other prescribed documents with the RoC).

The investee company is further obliged to maintain:

• Form PAS-4 (private placement offer letter);
• Form PAS-5 (record of a private placement offer to be kept by the company);
• registers of directors and shareholders;
• approvals at board and shareholder level with respect to the transaction (as may be applicable); and
• other books and records in accordance with the Companies Act.

Reserve Bank of India: The RBI, as India’s autonomous central bank, is empowered to frame laws in respect of the administration of all foreign exchange transactions under FEMA and acts in this regard, in tandem with the Indian government, through the Ministry of Finance and the Department for Promotion of Industry and Internal Trade, which issues the Foreign Direct Investment (FDI) Policy applicable to inflows of foreign investment. The RBI regulates the transfer or issue of any security by and among persons resident outside India and Indian residents, including Indian companies. When a private company is raising funds from a foreign investor, such companies must submit various regulatory filings to the RBI, including:

• Form FC-GPR, in the event of a fresh issuance; and/or
• Form FC-TRS, in the event of the transfer of existing securities.

The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 set out the key legislative framework applicable to foreign inflows and outflows of investment and specify the various associated conditions, such as:

• pricing guidelines;
• remittance of sale proceeds; and
• reporting requirements.

Consolidated FDI Policy: The Consolidated FDI Policy also regulates the inflow of foreign investment into India and imposes general conditions as well as sector-specific limitations, conditions and other restrictions on such investments. It distinguishes between:

• the ‘automatic’ route, where no prior investment approvals are required (although, in order to properly make the investment and secure the proper benefits of this route, certain reporting and compliance requirements post completion of the funding must be met); and
• the ‘government’ route, which requires prior government approval for investments in companies in certain industries or beyond certain sectoral caps.

In certain circumstances – depending on factors such as the quantum and type of transaction or the industry sector of the target – private equity transactions are also regulated by other regulatory authorities (largely sectoral or market-specific bodies), such as:

• SEBI (the securities market watchdog);
• the Competition Commission of India;
• the Insurance Regulatory and Development Authority; and
• the Pension Fund Regulatory and Development Authority.

The powers of each of these authorities to govern private equity transactions are, in addition to other miscellaneous parameters, triggered predominantly by:

• the nature of the investment transactions;
• the parties involved;
• the business in which the company operates; and
• other factors that trigger the various regulatory requirements.

An Indian company must comply with various formalities and filings with relevant regulatory authorities when raising funds. A snapshot of these key regulatory conditions and requirements for investment in an unlisted Indian company is set out below:

• Fresh issuance of shares (primary transaction):
• • A board resolution and shareholders’ resolution authorising the issue and allotment of shares. The shareholders’ resolution must be filed with the applicable jurisdictional RoC and the Companies’ Registry;
  • A board resolution approving the filing of Form PAS-4 (private placement offer letter), which must be filed with the applicable jurisdictional RoC;
  • Form MGT-14 (filing of resolutions and/or other prescribed documents to the RoC), which must be filed with the applicable jurisdictional RoC;
  • Form SH-7 (if authorised capital has been increased to provide more headroom for shares), if applicable, which must be filed with the applicable jurisdictional RoC;
  • Form PAS-3 (return of allotment of shares), which must be filed with the applicable jurisdictional RoC;
  • Form PAS-4 (private placement offer letter), which must be maintained by the company;
  • Form PAS-5 (record of private placement offer letter), which must be maintained by the company;
  • A valuation report and certificate stipulating the valuation of shares, which must be maintained by the company; and
  • Form FC-GPR, in case of the issue of shares to a foreign investor along with prior RBI approval, if applicable, in accordance with the FDI Policy, which must be filed through and with the concerned bank/authorised dealer in foreign exchange.
• Transfer of existing shares (secondary transaction):
• • A board resolution registering the transfer of shares;
  • Form SH-4 (securities transfer form) along with the original share certificate, which must be handed over to the company by the transferor; and
  • Form FC-TRS, if FEMA is applicable.
• Additional compliance for foreign investment (FEMA):
• A board resolution registering the transfer of shares; and
• Form SH-4 (securities transfer form) along with the original share certificate, which must be handed over to the company by the transferor.

Valuation: The Companies Act, the Income Tax Act and the FEMA regulations, as applicable, set out specific conditions to determine the fair market value of the shares of a company, which shall be determined by a registered valuer, subject to the company’s financial status and business operations. This determines the price at which most issuance or transfer transactions must be consummated.

Registrations: All investment-related agreements must be:

• duly stamped under the relevant stamp statute, whether state or federal; and
• to the extent applicable, registered under the Registration Act, 1908.

Multiple options are available to an investor to structure investment transactions in India entities. It is critical to examine two fundamental aspects prior to delving into the options available to an offshore investor to structure investments into India:

• the instrument of such investment; and
• the entity making the investment or through which such investment is undertaken.

Instrument of investment: Indian law offers a variety of investment instruments, which ultimately trickle down to the base category of all securities – namely, common stock or equity shares, with preference shares or convertible debt instruments featuring in precedence above such common equity. Convertible preference shares are typically preferred, as they come with preferential rights in terms of repayment in the event of liquidation and dividend. Preference shares are, by law, redeemable or convertible at the latest within 20 years of the date of issue and are thus typically structured as being mandatorily convertible within this timeframe, in the interests of investors. Convertible debt instruments convert into equity in accordance with the terms and conditions of the underlying agreement. Typically, the conversion of such instruments is linked to a discounted price per share in the next round of financing of the target, depending on the stage of the company and the negotiated position. Preference shares are also chosen by investors in view of the relative ease in exit situations and their appeal to potential buyers, as opposed to other instruments. In a foreign investment situation, the law mandates that whatever equity-linked instrument is used, it must be mandatory, fully and compulsorily convertible into equity shares as contractually agreed.

Entity of investment: The entity making the investment or through which such investment is undertaken is linked to a critical, fundamental consideration – the location of such investment vehicle. A foreign investor may choose one of the following options:

• It can invest in its own local or jurisdictional capacity with or through an entity that is a resident of, or through its local investment entity in, its jurisdiction of incorporation – that is, foreign direct investment (FDI) in the Indian entity coming directly from overseas with no onshore presence;
• It can invest through or establish an entity which is a pooled fund or such other investment vehicle located in an offshore jurisdiction (the choice of location is typically dependent on the relationship of that jurisdiction with India in terms of applicable bilateral investment promotion and protection agreements and double taxation agreements); or
• It can invest by contributing to, or setting up, an onshore entity which is subject to Indian regulatory oversight and applicable law, such as an alternative investment fund (AIF). The Securities Exchange Board of India (SEBI) provides a comprehensive framework for registration and regulation of AIFs in India, which may be set up as a trust, a company or a limited liability partnership under Indian law. AIFs are privately pooled investment vehicles which collect funds from investors – whether Indian or foreign – to invest in accordance with a defined investment policy for the benefit of the investors. AIFs may further be categorised as Class I, II or III, depending on the nature and complexity of investment being undertaken. AIFs are subject to such compliance and reporting requirements as may be required by SEBI and other regulators (depending on the nature of the fund entity) from time to time.

Once the choice of instrument and entity has been settled, a private equity investor may choose to directly subscribe to (in primary mode), or to acquire (in secondary fashion), the shares of an Indian target at a price per share based on a valuation report issued by a specified expert as required under applicable law, by investing onshore in India from offshore, as follows:

• Primary investment by subscribing to fresh shares issued by the Indian target:
• • The target must ensure that it has the authorised share capital to issue such fresh shares and, if not, must take necessary corporate action under the Companies Act to duly increase its authorised share capital, which typically involves the payment of certain fees and filings with the applicable jurisdictional Registrar of Companies.
  • Shares are then issued on a ‘rights basis’ or pro-rated basis in accordance with the existing shareholding (where new investors come in after such rights are refused or declined, or lapse), or through a private placement process by making an offer to investor(s), subject to and in accordance with the Companies Act. Most private equity transactions follow the private placement route for such primary issuances, in view of the regulatory and tax-related complications associated with adopting the ‘rights basis’ issuance route in cases involving foreign investors or entities that are not already shareholders or members of the Indian entity.
• Secondary investment by purchasing existing shares of an Indian target from its existing shareholders:
• • The selling shareholder(s) and the buyer typically enter into a share purchase agreement whereby the seller undertakes customary responsibility for absolute title to the shares and the unencumbered right to transfer such shares.
  • The parties must sign the share transfer form for the transfer of physical shares or, in case of the transfer of dematerialised shares, follow the necessary procedures in place with their respective depositories to complete the transfer, in accordance with applicable law.
  • The company must register and record the transfer of shares and update its register of members when notified in this regard.

A ‘combination transaction’ is a combination of a primary investment and a secondary investment. Other options to associate with a target include subscribing to convertible notes and simple agreements for future equity, which are relatively simpler but ultimately result in standard transaction documents.

In terms of transaction structuring, private equity investors may also consider an ‘externalisation’ structure or an ‘offshore’ structure, as distinct from the direct onshore investment structures described above. Private equity investors primarily resort to this structure in order to avoid being caught by Indian regulations and restrictions, and to legally sidestep both the Indian legal system (and its legendary delays) and its often notorious bureaucracy.

This ‘externalisation’ structure involves the establishment of a foreign holding company of the Indian entity in a tax or regulatory-friendly jurisdiction, or one which has a close connection commercially with India, such as Mauritius or Singapore, which then holds 100% of the operating Indian entity. All private equity investment then occurs at the overseas holding company level, with a flowthrough contractual structure put in place to regulate the Indian wholly owned subsidiary and downstream the private equity investors’ rights at the overseas level through to the operating Indian entity. While this structure appears to achieve the objective of avoiding the Indian legal system mentioned above, the various issues and potential downsides associated with this transaction structure are outlined in question 3.4.

While the aforementioned construct encapsulates the four corners of applicable law and general practice in the context of investment transactions in India, the law affords significant discretion to parties in structuring the deal, such as:

• deferment of the purchase consideration;
• splitting of the purchase consideration into one or more tranches;
• retention of specific percentage of funds in escrow;
• indemnity gross-up;
• typical negative covenants; and
• transfer restrictions such as right of first refusal and non-compete restrictions.

A primary investment (ie, the issuance of fresh shares) ensures that the shares are not encumbered, provided that all necessary corporate and regulatory action validating the due authorisation and issuance of the shares has been undertaken. A secondary transaction for the purchase of existing shares, on the other hand, may carry the risk of losing or limiting the title to the purchased shares, depending on the acts or omissions of the seller, which may or may not be revealed by the seller. Such acts or omissions may have the effect of potentially encumbering or restricting the buyer’s rights to such shares being purchased. In both cases, appropriate due diligence is paramount to ensure that appropriate risk mitigation can be timely undertaken and documented – ideally prior to the transaction’s completion.

Since the target is also the direct recipient of the primary investment, it becomes easier to achieve and realise the value of the investment, given that the company can be sued directly for loss of any such value; and importantly, all rights vis-à-vis the shares and the investment can be directly enforced through the company’s articles of association against the company itself and its shareholders. On the flipside, in a secondary transaction, it may become difficult to follow the selling or exiting investor, as that person may no longer be within the jurisdiction of the target, for the private equity investor to sue and recover from both the target entity and its previous shareholder simultaneously.

Both primary and secondary investments require extensive due diligence on:

• the target;
• the promoters; and
• as applicable, the selling shareholder.

Such due diligence is subject to a fair share of risks and uncertainty in relation to various aspects of the target, including:

• the assets of the target;
• its financial position;
• taxation issues; and
• claims and litigation.

As stated in question 3.1, the choice of instrument and choice of investment vehicle are key determinants in arriving at the transaction structure. Private equity investors may undertake FDI (ie, invest into India offshore directly from their overseas entity or fund). In other words, the investor directly utilises its overseas fund or entity as the investment vehicle – as incorporated or typically situated in a country with which India has a favourable double taxation treaty – so as to legitimately obtain associated benefits. Such an offshore funding structure enables the investor to pool its funds overseas and invest into India without the need to register its overseas investment vehicle in India. This has proven to be a cost-effective strategy and has been adopted by various private equity investors into India.

By adopting this offshore route of funding, a private equity investor benefits significantly from not being required to register its investment vehicle in India. That said, two important restrictions or requirements arise:

• It is vital for the private equity investor to establish that it is a resident only of the country in which it is incorporated overseas, so as to ensure that it can take full advantage of the benefits of the double taxation treaty between the place of its incorporation and India; and
• Depending on the type of offshore funding structure that it has in place, the investor will continue to be subject to the Indian pricing regulations with respect to the valuation at which it invests in, or exits from, the Indian entity. In other words, an offshore private equity investor can invest in or exit from India only by adhering to the fair valuation mechanisms in terms of price of the subject shares, as stipulated and as calculated in accordance with applicable Indian regulations, depending on the residential status of the transferee, among other things.

Alternatively – and, critically, depending on whether the sources of its funds or its own limited partners are foreign vehicles investing in US dollars or other foreign currency or Indian domestic investors investing in Indian rupees – private equity investors may also consider setting up an AIF under the SEBI (AIF) Regulations, 2012, to pool their investment funds onshore in India and invest therefrom not as FDI, but as a domestic rupee-based investment.

In following an onshore funding strategy, the private equity investor must register the AIF in India and will thus become subject to various reporting and other requirements which are typically applicable to entities governed and regulated by the registering authority in India – in this case, SEBI. However, AIFs benefit from the free pricing mechanism available under Indian law as regards investments in, or transfers of the shares of, an Indian entity.

However, the SEBI guidelines for AIFs and other fund structures and Foreign Exchange Management Act, 1999 (FEMA) guidelines impacting overseas investments (including in relation to pricing) and the tax structures must be closely examined prior to the transaction; and the conditions mentioned in the respective guidelines must be satisfied.

The advantages and disadvantages of various funding structures are based on:

• the type of fund or investor; and
• the registration requirements under the applicable SEBI regulations.

The pricing guidelines under the Companies Act, FEMA and the Income Tax Act must also be considered in relation to the private equity investment based on the type of funding structure. Any private arrangement with respect to exit from investment cannot be made in excess of fair value; hence, it is recommended that the fair value of the target be continuously monitored in the interest of a lucrative exit.

However, various restrictions and guidelines are in place to ensure that no shell companies retain income outside India despite the company’s management taking place in India. For instance, the concept of ‘round-tripping’ – whereby Indian funds held in overseas entities are reinvested in an Indian entity as FDI – is generally prohibited under FEMA. Additionally, if a company’s place of effective management is in India, it will be treated as an Indian resident and its global income will be taxable in India. The ‘place of effective management’ construct has broad regulatory scope and the Indian tax authorities have significant discretion in determining whether an entity has a ‘place of effective management’ in India. This has particularly been the basis for parties to a transaction to avoid externalisation.

In order to curb round-tripping of funds, regulations of the Income Tax Department of India, the Reserve Bank of India (RBI) and the Enforcement Directorate (under India’s foreign exchange laws), along with the general anti-avoidance rules, apply to any situation where a particular route of investment through a foreign entity is chosen with the intention of evading or avoiding taxes under Indian law.

Foreign or non-resident taxpayers involved in such transactions should seek specific advice on: the tax payable in India for potential transactions in India, including in light of:

• whether the transaction is a primary or secondary transaction; and
• any double tax treaty between their tax region of residence and India.

Such tax advice should also entail a review of implications, risk management and allocation strategies in the case of purchase of shares through a secondary transaction – particularly in the context of taxes that should have typically been paid by the seller prior to or in connection with the subject sale to the investor. Subject to such tax advice and applicable law, any excess tax payable in India must be duly pre-assessed and paid by such foreign tax resident.

Cross-border private equity transactions are governed by regulations issued by the RBI, specifically under FEMA. Key factors to be considered in cross-border private equity transactions are the pricing regulations (including the method to determine valuation of shares) and taxation laws applicable to the transaction. The shares issued to, or purchased by, a foreign investor are closely monitored by the RBI through the mandatory filings and disclosures, including the annual return of foreign liabilities and assets made by companies and filed with the RBI.

The RBI also restricts and regulates payment processes in private equity transactions. For instance, the RBI restricts deferred payment for the purchase of shares between a resident buyer and non-resident seller and vice versa, as follows:

• Not more than 25% of the total consideration for the purchase of shares shall be deferred; and
• Such deferred payment must be made within 18 months of the date of execution of the transfer agreement.

In addition, the tax status of a foreign investor or seller must be appropriately warranted by such foreign investor for the purpose of determining the tax implications of such cross-border transactions, which may also be affected if India is a party to a double taxation treaty with the host country of the foreign investor or seller.

Yet another key issue that should be thought through while structuring cross-border transactions is the dispute resolution mechanism. While the parties can agree to any mechanism, the ease in potential enforcement of any judgment or award and liability for associated costs should also be premeditated. Arbitration is the preferred dispute resolution mechanism that is typically selected by the parties to a cross-border investment. India is on its way to becoming a preferred arbitration destination in view of the increasing reluctance of Indian courts to interfere with arbitration awards and the efforts of the Indian government to promote institutional arbitration.

Where multiple investors are involved in a single round of private equity investment in a target, it may become operationally challenging to obtain individual consent from each investor for certain decisions of the target or to convene meetings for the exercise of their voting and governance rights. Most companies execute shareholders’ agreement with their investors to categorise and divide their investors into similar groups, which may then potentially jointly exercise their rights in the company.

The following key factors must be considered prior to documenting the rights, obligations and restrictions of such investors in a transaction document and making appropriate filings in relation thereto:

• Differentiation based on classes of shares: If different investors subscribe to or purchase different kinds and classes of shares, the terms of such shares will differ between the investors; and
• Differentiation based on categories of investors: The rights associated with the shares issued to or purchased by investors (eg, veto rights, exit rights, transfer restrictions, governance rights and liquidation or distribution preferences) may vary among different types or classes of investors, and/or may depend on the value (and timing) of their respective investments.

In the case of multiple foreign investors, it is important to determine which investor requires governmental approval for investments into companies in certain industries and sectors, as specified in the Consolidated FDI Policy, and which may invest through the ‘automatic’ route. For instance, as earlier mentioned, the Consolidated FDI Policy was revised in April 2020 to mandate prior government approval for all investments from all foreign investors or beneficial owners of an investor that are registered in or citizens of a country that shares a land border with India. The pricing for such foreign investors must also not exceed the fair market value of the shares of the company.

A typical private equity investment transaction in India generally involves the following key steps and milestones along the way:

• Term sheet: The parties may set out the commercial understanding of their respective rights and obligations in a term sheet or letter of intent. The term sheet is typically non-binding and, when signed, serves as a guiding document for drafting of the chief transaction documents, which typically includes:
• • the shares’ subscription agreement (for a primary transaction) and the shareholders’ agreement (for documenting inter se rights and obligations of shareholders); and/or
  • the share purchase agreement (for secondary transactions), as applicable.
• Due diligence: Once the term sheet is in place, the investor usually conducts legal, financial and business (and sometimes operations and technical) due diligence on the target and undertakes a background check on the promoters of the target. The intensity of the due diligence to be undertaken depends on various factors, including:
• • the stake being acquired;
  • the risk appetite;
  • the age of the company; and
  • the costs involved.
• The costs associated with the due diligence are typically negotiated extensively between the parties.
• Investment documents: The parties finalise investment agreements pursuant to the provisions of the term sheet, subject to any modification or negotiation of terms or conditions based on the due diligence reviews obtained by the investor.

The findings from the due diligence are incorporated into the investment agreements as conditions precedent, conditions subsequent and/or specific indemnities, and the foregoing construct is typically negotiated depending on:

Once the money has been transferred, the company will issue the shares or the transferee will acquire the shares, as the case may be; and the associated compliance will be undertaken. The investor typically receives a share certificate along with a Form SH-4 (securities transfer form) (if the transaction pertains to the transfer of existing shares) as evidence of the shares it holds in the company.

The post-closing actions or conditions defined in the agreement continue to be obligations of the company after the money has been wired.

The due diligence conducted into the affairs of the target usually includes:

• legal due diligence;
• financial and taxation due diligence;
• business/commercial or operational due diligence; and
• other aspects, including information technology, human resources and intellectual property.

The advisers engaged by private equity firms to carry out the due diligence typically classify the risks identified through the due diligence review as high-risk, medium-risk and low-risk issues.

While the general and stated objective of such due diligence is to verify the basis for the valuation of any particular private equity investment deal (and to provide any adjustments thereto, depending on the due diligence findings), the legal obligation created thereby is one of actual or constructive knowledge. Such knowledge may be affixed to the private equity investors as a result of the due diligence and may affect the indemnification rights of such investors arising from any breach of the representations and warranties provided by the promoters of the target.

In addition to the due diligence on the company, most investors run a background check on the promoters and key managerial personnel of the target.

As in most common law jurisdictions, it is in the hands of the private equity investor to observe the principle of caveat emptor (buyer beware) and ensure that it is satisfied (or otherwise) as to the state of affairs of the target and the extent of the liabilities and obligations of the target on closing, in order to claim necessary protections through indemnities provided by the target. In other words, any reliance on representations and warranties provided by the target will be caveated by:

• the extent of the knowledge of any pre-existing liabilities (whether actual or implied); and
• how such knowledge can be excluded legally.

This is typically coupled with a range of disclosures that the promoters make in response to or caveating, as appropriate, the representations and warranties they provide. This further depends on the negotiations between the investor and the promoters as to how pre-existing risks and liabilities are handled and adjusted between the parties in the context of completion of the investment transaction. The foregoing risk allocation construct is typically highly negotiated in transactions.

The parties may choose to be bound by mutually agreed restrictions and disclosures under contract, in addition to securing regulatory compliance applicable to the transaction. Typically, the promoters of the target are bound by various restrictions, such as:

• limited ability to transfer their shares;
• exclusivity;
• non-compete;
• non-solicitation; and
• confidentiality.

Given that there is no specific statutory mandate governing the contractual position regarding requirements and restrictions, the parties negotiate extensively and arrive at a mutually agreed contractual position. This mutually agreed position may then be incorporated into the company’s articles of association to give it statutory teeth and is typically cast as a closing obligation on the investee company.

Typically, private equity investors seek a comprehensive set of representations and warranties from the investee company and its promoters (or, in case of a secondary transaction, from the target and its promoters, as well as the selling shareholders) in relation to:

• the capacity to execute the investment agreements and complete the transactions contemplated therein;
• business warranties;
• corporate governance warranties;
• tax warranties;
• warranties in relation to litigation against or by the target; and
• any other warranties that may be required from the target in relation to the findings of the due diligence, its business or the type of industry in which it is involved.

While private equity investors seek representations and warranties pursuant to their due diligence on a target, most warranties are sought from the target regardless of any due diligence. The target is also given the opportunity to make any disclosures against such representations and warranties to the investor which, if accepted by the investors, become a safety valve for the company.

As in most other common law jurisdictions, the target and any selling shareholders have no general duty to disclose – except, crucially, where the investor has sought an explanation or information and the same has been denied or ignored. In other words, it is in the best interests of the target to make the maximum possible disclosures in order to obviate its obligation to indemnify the investor – subject, of course, to any confidentiality obligations that it may have with regard to any such disclosures, in which case advance consent for such disclosures may be required. As mentioned in question 1.2, much depends contractually on:

• where and how the risks and liabilities are allocated or adjusted between the buyer and the sellers; and
• the negotiating strengths or weaknesses of either party.

In the absence of such contracts to the contrary, the underlying principle of Indian law is ‘buyer beware’.

Private equity firms must ensure that the representations and warranties are true and accurate, especially as regards the source of the target’s funds, so as not to fall foul of India’s anti-money laundering laws in particular. Such entities must also ensure that the investment transaction is duly authorised for them to enter into and to execute.

Other than the target, its promoters, any selling or existing shareholders of the target company and the investors, the advisers and other stakeholders involved may include, without limitation:

• directors of the target;
• employees of the target (generally key employees or managerial personnel);
• creditors and debtors of the target;
• customers of the target; and
• legal, tax, compliance and financial advisers.

An investor may require the fulfilment of certain conditions precedent prior to closing the transaction, as specified in the negotiated investment agreement. If these conditions precedent are not fulfilled (or are not waived by the investor), the investor is not obliged to complete the transaction and may terminate the investment agreement.

Conversely, the target or the selling shareholders may seek either specific performance of completion of the transaction or damages for any expenses incurred if the investor chooses not to invest once the conditions precedent have been satisfied by the target and/or the selling shareholder(s). Conditions precedent may include:

• legal and regulatory approvals;
• third-party consents, such as consent from lenders;
• confirmations on compliance with tax laws and other requirements under applicable law; and
• conditions arising from the due diligence conducted on the target.

In addition, private equity investors generally seek closing accounts from the target which indicate the financial position of the company on the closing date (ie, the date of completion of the transaction). Private equity investors may also negotiate a ‘locked-box’ mechanism with the target, whereby the investment amount is fixed based on historical financial statements in the investment agreement and is protected through the covenants, warranties and indemnities provided by the target or the selling shareholder(s) to the investor.

The parties may agree upon permitted reductions to the valuation of the target (‘leakages’) between the date of execution of the investment agreement and the date of completion of the investment transaction. The advantage of the locked-box concept is that the investor has visibility and control over the price of shares being issued or purchased without any significant variance between the date of execution and the date of completion of the transaction. However, this may not be feasible if the period between the execution date and the completion date is too long, and the target attempts to cover any major costs as permitted reductions (which remains a matter of commercial negotiation). Furthermore, the private equity investor may choose alternative protective mechanisms, such as the escrow of consideration payable or the dematerialisation of physical shares ahead of closing. However, the escrow mechanism may be expensive in certain cases, depending on the timeframe for completion of the transaction. In addition, the escrow of a portion of the consideration cannot be deferred beyond 18 months from the transfer agreement date; and not more than 25% of the total consideration may be escrowed in accordance with the Foreign Exchange Management Act regulations.

Break fees are deal protection measures whereby a party to a transaction agrees to pay a fixed fee to the other party if the transaction is not consummated due to the occurrence of a specific event provided in the investment agreement. Although not very common, break fees are permitted in Indian private equity transactions and are a matter of contractual agreement between the parties. The parties may agree on break fees and specific performance measures in the investment agreement if either party voluntarily disrupts or chooses not to complete the transaction.

The break fees are generally held in escrow, and the parties may agree on the events that trigger payment of the break fees (subject to any exceptions recorded in the investment agreement), such as the following:

• The target or a selling shareholder chooses a different investor;
• Either party decides to stop negotiations; and/or
• Any disclosures are made or facts arise in the due diligence process which may affect the investor’s decision to consummate the transaction.

An important exception that must be considered in this regard is the extent of the application of any force majeure events, such as modifications to the foreign direct investment regulations requiring prior government approval of any investments from neighbouring countries, aimed at Chinese investments into India.

Investor risk: A private equity investor enters into a transaction with a target or a selling shareholder based on representations and warranties provided by the seller and covenants provided under the relevant underlying agreements. Any breach of such representations and warranties which may cause losses to the investor entitles the investor to seek indemnity for reimbursement or recovery of such losses under the agreement. Investors also typically seek contractual and mandatory voting or decision-making rights in relation to specific key matters, and may restrict the promoters (especially in the case of earlier stage entities) from transferring their shares for a fixed period following the investment. The foregoing rights are typically incorporated in the articles of association of the company, which gives the contractually agreed position statutory force. The promoters must also comply with extensive restrictions in the nature of exclusivity, non-compete, limited ability to invest in other companies and non-solicitation obligations. Any key issues identified in the due diligence process are typically positioned as conditions precedent in the agreement, which enables the investor to withdraw from the agreement without wiring the funds if such conditions are not met. The investor may also seek a right to appoint a non-executive director or observer to the board of the target. However, a director on the board is statutorily obliged to comply with roles and responsibilities in connection with the company.

Company/promoter risk: The promoters and existing shareholders of the target may be diluted by the private equity investment and the rights in relation to their shares may be reduced as a result. The target and the promoters are obliged to provide an exit for the private equity investors within a timeframe specified in the relevant investment agreement; but this may be difficult if the business of the company is adversely impacted. The target and its promoters will also:

• make necessary disclosures to the investor against the representations and warranties made under the investment agreement at the time of making such representations and warranties; and
• agree to indemnify the investor in case of any issues or claims that arise in relation to such representations and warranties.

Indian law allows an investor to rescind an investment agreement for misrepresentation. However, a misrepresentation (even a fraudulent one) does not entitle the investor to rescind the agreement to invest if it could have discovered such misrepresentation through ‘ordinary’ diligence. Breaches of warranties, on the other hand, give rise to a claim in damages, but not to a right to repudiate the contract of investment. Whether a stipulation in a contract of sale is a condition or a warranty depends in each case on the construction of the contract. A stipulation may be a condition, though it is called a ‘warranty’ in the contract. To that extent, therefore, Indian law – like English law – distinguishes between a misrepresentation and breach of a warranty; although it remains to be seen how much Indian law has moved away from this distinction through the use of the ubiquitous indemnification remedy, rather than damages.

All parties involved in an investment transaction may be affected by a material adverse change in the business and operations of the target. A ‘material adverse change’ refers to the occurrence of any event or change which may adversely affect the business or operations, financial conditions, assets or performance of the target. If a material adverse change occurs, the private equity investor may choose to opt out of the investment or reduce the investment amount. Acceleration of exit is typically sought by foreign investors as a post-closing remedy in case of the occurrence of any event of default or material adverse effect that impacts on the investor’s interests.

An investment agreement generally includes representations and warranties, which are statements of facts that are true at the time of execution of the agreement and at the time of consummation of the transaction (ie, wiring of the funds). These include standard warranties as stated in question 4.3.

The scope of the representations and warranties provided by the target and its promoters and/or any selling shareholders depends on the type and size of the transaction. Typically, the investor seeks indemnification from the target and its promoters in case of any breach or misrepresentation of the warranties provided by them, and may also seek specific performance for specific items. The target and its promoters may provide necessary disclosures against the representations and warranties, as explained above.

Certain companies and promoters may choose to obtain insurance for any indemnity claims arising from the breach of representations and warranties to limit their losses from indemnity claims. This indemnity insurance may be structured based on:

• the consideration involved in the transaction;
• the insurance obtained by the company;
• the indemnity caps agreed between the transacting parties; and
• other transaction-specific factors.

Similarly, the investor may also obtain insurance for any breach of warranties if the indemnity provided by the seller is limited. If the investor appoints a director to the board of the target, the target is typically obliged to procure directors’ and officers’ liability insurance. However, while the indemnification obligation may be contractually agreed, it remains independent of any claim in relation to damages under applicable law.

Targets generally offer the following management incentives to ensure that management-level personnel use the private equity investment to meet the milestones agreed with the investor(s):

• Employee stock options (ESOPs): ESOPs are the equity compensation which is granted to the employees and executives of the target. The target sets out a vesting schedule and provides the employees with the right to buy shares in the company at the specified price within the specified timeframe. ESOPs are granted under a governing ESOP plan approved by the board of directors and cannot be issued to independent directors, promoters of the company (which is an important exception) or any director holding 10% or more of the shares of the target, among other criteria, exceptions and conditions.
• Stock appreciation: These are rights granted to the employees of the company as a form of bonus. The performance goals are set by the target and, upon fulfilment of such goals by the employees, an exercise period is allocated within which the employees can claim the cash allocable towards their stock appreciation rights. The employees need not pay any exercise price and are entitled to a sum of the increased stock price, either in cash or in equity. This mechanism is also beneficial for the company, as there is no dilution of the shareholding of the company and the bonus is paid subject to the company’s performance.
• Sweat equity shares: These are rights granted to employees for the ‘sweat of the brow’ – in other words, their performance – to show appreciation for their efforts. A company granting sweat equity shares will generally specify the performance parameters on the basis of which the sweat equity shares may be granted or exercised. A company may issue sweat equity of a maximum of 15% of the paid-up equity capital or INR 50 million in a year, whichever is higher, without prior government approval. The total issued sweat equity shares in a company cannot exceed 25% of the total paid-up capital of the company at any time. Registered start-ups are exempt from this rule and may issue sweat equity shares up to 50% of the paid-up capital for a period of five years from the date of incorporation. Sweat equity shares are locked in and non-transferable for at least three years from the date of allotment, in accordance with the Companies Act and the rules established thereunder.

The advantages and disadvantages of these structures may vary based on:

• the type of company and the industry in which it operates; and
• any commercial policies that the company and its investors may implement to incentivise employees.

Subject to the company’s performance and preference, the company may determine the percentage of such options and incentives (on a fully diluted basis) and the vesting period for the same.

ESOPs: ESOPs are considered perquisites at the time of their exercise, where the difference between the fair market value and the exercise price is taxable and is treated as income from salary. If the ESOP holder decides to sell any shares from the exercise of his or her ESOPs, the difference between the fair market value and the sale amount shall be taxed as capital gains earned during that financial year. For the company, the issuance of ESOPs may be considered a general expense which may be deductible under the Income Tax Act, 1961 subject to certain conditions thereunder.

Stock appreciation: The value from stock appreciation rights is taxable as a part of the total income from salary of the employee holding such rights. At the time of exercise of the stock appreciation rights by the employees, the difference in fair market value of the shares allotted and the exercise price is treated as a perquisite. The company may claim the amount of appreciation paid to the employee in cash as expenses under the Income Tax Act, 1961 and the company is obliged to deduct tax at source on such payment of compensation to the employee.

Sweat equity shares: Sweat equity shares are also taxed as perquisites under the Income Tax Act, 1961, subject to the conditions set out thereunder.

While the strategies to mitigate tax exposure may vary based on the quantum of the exercise price or the value of the options, companies typically draw out the vesting period of such options to reduce the tax burden during each financial year.

Manager shareholders are generally given the following rights:

• governance rights (a seat on the board of directors of the company being the key one);
• transfer rights such as tag-along rights;
• pre-emptive rights; and
• such other general rights as may be agreed between the shareholders of the company, subject to the shareholding percentage of the manager shareholders.

The shares of manager shareholders may be subject to various transfer restrictions, including:

• a lock-in for a fixed period to ensure continued employment and engagement with the company;
• a contractual encumbrance on their shares, which are released in a phased manner during the intended period of investment by the investor;
• an obligation to offer their shares to the investor prior to offering them to any third party; and
• consequences of termination of their employment (whether for cause, as defined under the agreement, or voluntarily by either the company or the manager shareholder).

Moreover, manager shareholders are usually subject to exclusivity, non-compete and non-solicitation clauses in the investment agreement, to protect the company from any losses due to competition by the manager shareholders after leaving the company.

Investors are drawn to companies with an able management and core team, which should allow them to gain greater returns on their investments. In other words, investors rely on management to ensure the financial growth of the company post-investment.

For this reason, most investors seek covenants from, and protective provisions in relation to, the manager shareholders of a company (and from other key employees, depending on the commercial understanding) and their continued employment with the company. If any manager shareholder leaves, the company may be adversely affected, which may have a knock-on effect for the investor.

In this context, the terms ‘good leaver’ and ‘bad leaver’ have been introduced for departing manager shareholders, depending on the reasons for their departure and the conditions set out in the transaction documentation for determination of good leavers and bad leaver. The respective leaver events are referred to as the ‘leaver provisions’ and the relevant provisions are included in the investment agreement.

A ‘good leaver’ is generally a manager who leaves the company voluntarily after following due process and for the following reasons, for which he or she is not responsible:

• death or incapacity due to prolonged illness or occupational disability;
• statutory retirement due to age;
• termination or release by the investor without good cause;
• mutual agreement between the manager and the investor; or
• refusal by the investor to extend the manager’s employment contract on the same terms without any cause.

Further, a good leaver usually receives the fair market value of his or her investment determined at the time of selling or transferring his or her shares in the company – that is, he or she participates in the increase in value of the investment.

A ‘bad leaver’ is a manager who is terminated from employment with the company for cause, which may include various reasons such as fraud, misconduct or wilful negligence. The sale and transfer of a bad leaver’s shares in the company are typically completed at a nominal value or transferred to the ESOP pool to incentivise the replacement of the bad leaver.

Private equity investors seek assurance and comfort from portfolio companies that their governance and policies are compliant with applicable laws and will protect the interests of shareholders. To this end, they will:

• negotiate with the target and appoint a nominee director to the board of directors; or
• seek an observer seat in order to keep abreast of board matters, proceedings and issues.

However, it is important to ensure in law that no observer becomes, or is considered to be, a director in fact or effectively a ‘shadow’ director.

Private equity investors also set out a list of veto matters for which their express consent must be sought by the company. Some private equity investors may also require the company to adopt policies in relation to:

• environmental laws;
• social and labour law;
• anti-corruption laws; and
• corporate social responsibility.

The most common governance arrangements between private equity investors and portfolio companies are the information and inspection rights sought by the investors. The company must provide an extensive list of periodic information and documents to the investors – including financial statements, management information system reports, budgets and performance reports – for verification and vigilance.

Private equity investors may also seek to amend the terms of employment of company employees. For instance, they may introduce or amend the indemnification, notice period, non-compete and non-solicitation clauses in the employment agreements for key managerial persons of the company, including the promoters of the company.

Private equity firms may negotiate and seek the right to appoint their nominees to the board of directors of companies in which they invest, to ensure that they have complete visibility on the affairs of the company and are involved in the decision-making process. Private equity firms must consider the following factors when nominating directors to the boards of portfolio companies:

• The interests of nominee directors must be disclosed in accordance with the applicable law to identify related parties;
• The past conduct of the nominee director must be disclosed, including any litigation for some fraudulent or other related activities;
• As executive directors, nominee directors are also liable in their fiduciary capacity to work in the best interests of the company with the objective of growing the company; and
• Nominee directors cannot make decisions in the exclusive interests of the private equity investor, as this may affect the company. They must ensure that all decisions are taken in the best interests of the company as a whole and all of its stakeholders.

The company must also discuss the terms of such appointment of nominee director, such as:

• the director being appointed in a non-executive capacity or not being considered an ‘officer who is in default’;
• any indemnification obligations of the company towards such directors; and
• any directors’ and officers’ liability insurance to be procured for such indemnification obligations.

An ‘officer who is in default’ under the Companies Act includes, among others, full-time director and key managerial personnel, as is relevant in the facts and circumstances. The terms of appointment of such nominee director should thus expressly state that such director is non-executive so as to ensure appropriate protection from potential categorisation as an ‘officer who is in default’.

Subject to the investment agreement between the target, its promoters and the private equity investors, private equity investors (especially those without a significant ownership stake) seek and are given contractual veto rights in respect of matters that may affect them, such as:

• corporate restructuring;
• alteration of the founders’ rights;
• fundraising;
• any material diversion, redemption or buyback or cancellation of securities;
• related-party transactions;
• the incurring of indebtedness;
• the creation of encumbrance over company assets, including IP rights;
• the disposal of assets;
• the appointment and removal of key managerial team members;
• litigation;
• a change in business;
• any initial public offerings;
• the purchase or lease of property; and
• the liquidation or dissolution of the company.

Under Indian law, the grant of veto rights is not deemed to give ‘control’ of the company to the veto rights holder. Instead, the veto rights are treated as protective provisions. In the absence of any powers to appoint majority directors on the board or to exercise control over day-to-day operations or policy decisions of the company, a shareholder with veto rights is not considered a ‘controlling’ shareholder merely by virtue of the veto rights, as Indian law currently stands.

The private equity investor may oblige the company and its promoters to seek its written consent in relation to such veto matters or seek consent at shareholders’ meetings or board meetings (where the private equity investor has a nominee director on the board). These veto rights may be sought by investors with a smaller stake in the company, which may be unable to influence any decisions taken by simple majority.

Such terms as are contractually agreed between the parties should be incorporated into the articles of association of the company, to ensure that all shareholders’ rights and obligations are appropriately captured in the governing charter document and to avoid any confusion where the contractual agreements provide something different from the charter document, as the law provides that in the event of any conflict or inconsistency between a contract and the articles, the latter will prevail (and the Companies Act prevails over both).

Governance rights: Private equity investors may participate in the operational and strategic decision making of the company through a nominee director appointed to the board and/or veto matters with the portfolio company and other shareholders. They may also consider appointing a nominee director with the requisite knowledge and understanding of the business of the portfolio company to better contribute to its operations.

Information/veto rights: The investors may be entitled to specific information or inspection rights in accordance with the terms of the investment agreements, to ensure that they have visibility of the company’s performance. The investors may also seek veto rights on certain matters of their interests.

Employment and operational activities: The investors may be involved in the hiring and compensation of employees. Investors may also conduct periodic reviews of compliance and company policies at the cost of the company.

Non-compete and non-solicitation covenants: Private equity investors may ask portfolio companies to seek non-compete and non-solicitation covenants from anyone (eg, an employee, director or shareholder) who is exiting the company stating that he or she will not work with or set up a competing business and/or solicit employees of the company.

Confidentiality: This is an important aspect that should always be addressed in an agreement or through appropriate non-disclosure agreements to ensure that none of the company’s confidential information is disclosed to anyone who is not intended to have access to such information (and is always subject to the same level of confidentiality and non-disclosure).

Observer seat: Investors may ask for an observer seat on the board of the portfolio company. This ensures that they have full access to all information without any voting rights. Observer seats strengthen the confidence of investors in the company. The rights and obligations of observers are usually agreed between the parties. Agreement in relation to the observer must clearly set out his or her extent of involvement, to avoid falling under the ambit of an ‘officer who is in default’.

Private sales and initial public offerings (IPOs): An IPO is a method by which a company’s shares are listed on the stock market for the first time. It provides a way to the investor to exit the company by selling its shares in the company’s portfolio. Given that an IPO ensures greater access to capital in international and domestic public markets, this has become a popular exit route for private equity investors. However, an IPO involves high transaction costs – notably due to legal restrictions and the market supervisor’s rules. Further, the terms of an IPO may prohibit the financial sponsor from exiting some or all of its position for a period of time called a ‘lock-up period’. Hence, these elements make an IPO a lengthy and expensive process.

Strategic sale/third-party sale: The sale of a significant or controlling stake in the company to a third party involved in similar businesses and/or interested in taking control of the operations of the company is one of the exit modes elected by private equity investors.

Drag-along rights: Rights that allow the majority shareholders to require the minority shareholders to sell their shares are known as ‘drag-along rights’. The objective of these rights is to provide liquidity, flexibility and an easy exit route for a majority shareholder. This right is usually given to and exercised by private equity investors if all other exit options fail or are not fulfilled by the company and the promoters.

Buyback/put option: Buybacks (the purchase and extinguishing by a company of its existing shares) and put options are typically used to end the private equity fund’s investment in an unsuccessful or distressed company. That said, repurchase of the investors’ shares is often seen as a last-ditch attempt to ensure an ‘exit’.

Dual-track process: This process allows a private equity investor to file for an IPO and simultaneously pursue a strategic acquisition. This involves the two exit modes at the same time and is thus known as a ‘dual-track’ process. Although this process is advantageous in the sense that it provides an opportunity to the private equity investors to explore the public market while also looking for a strategic purchaser, it is quite expensive to adopt two procedures in parallel and is thus not common in practice.

A management equity holder or promoter that is ‘locked in’ as a promoter and employee of the company in the deal document in lieu of a private equity investment cannot leave (or engage in fraud, embezzlement, wilful breach, misconduct, wilful negligence, any crime involving moral turpitude or significant non-performance leading to termination) for such lock-in period. Subject to the transaction structure, in the event of termination of the employment or engagement of a manager or promoter during the lock-in period or the occurrence of a material breach which is typically categorised as an event of default in the transaction documents, a private equity investor may negotiate an accelerated exit either through a buyback by the company or through a drag-along right as specified above.

Each of the exit strategies outlined in question 8.1 is subject to the regulations set out in the Companies Act and the rules framed thereunder; and, in the case of an IPO, must accord with the Securities Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018. There are various conditions and restrictions on such transfers of shares under the Companies Act. For instance, a buyback by a company must be authorised by the articles of association (or appropriately amended by special resolution passed by the shareholders) and approved by the shareholders, subject to various conditions, including the following:

• The buyback must be less than 25% of the total paid-up capital and free reserves of the company; and
• The buyback cannot be initiated less than a year after completion of the last buyback by the company.

In case of an IPO, the red herring prospectus issued by the company initiating the IPO must specify the types of securities and the persons selling in the IPO, in accordance with the articles of association of the company (in case of any contractual limitations) or in accordance with applicable law.

Primary investments in Indian companies are not taxable in the hands of the investor at the time such investments are made, unless the shares have been issued below fair market value. In such case, the investor is taxed on the difference between the acquisition price and the fair market value of the shares, as this is treated as income in the hands of the investor. The transfer of shares of an Indian company is taxable depending on whether the transfer is completed at a price per share which lower or higher than the fair market value of such share. If the consideration is lower than the fair market value of the share, the buyer is taxed on the capital gain, which is the difference between the consideration and the fair market value of such share. Similarly, if the consideration is higher than the fair market value of the share, the seller is taxed on the capital gains calculated in the same manner.

Subject to certain exemptions available under relevant tax treaties between India and the country of residence of the investor, a non-resident investor is taxed in India. The gains from the sale and transfer of shares are taxed (or not taxed at all, depending on the tax treaty) based on factors such as:

• the period of holding;
• the type of holder; and
• the type of company.

As specified in question 3.3, the parties to cross-border private equity transactions must also consider the implications of the place of effective management of the overseas investor deemed as being in India, as this may lead to the ‘round-tripping’ of funds or qualification as a tax resident of India.

The risks and opportunities in relation to indirect taxes applicable to private equity transactions may be determined based on the nature of the transaction. All parties involved in an investment transaction generally obtain tax advice to structure the transaction in a cost-effective and tax-friendly manner. Every investee company must obtain a valuation report determining the price per share prior to consummation of the investment transaction, to ensure that it is compliant with all pricing guidelines under the Income Tax Act, 1961 and the Companies Act and, where applicable, the Foreign Exchange Management Act, 1999.

While the Goods and Services Tax Act, 2017 (GST) affects the transfer of business by way of ‘slump sale’ or the purchase of assets of a company as a going concern, if a business is acquired through the transfer or sale of shares, there will be no GST implications, given that the definition of ‘goods’ and ‘services’ excludes stocks, shares and similar from its ambit. Further, even in the case of a merger or demerger or amalgamation of companies, no GST is attracted, as this is the transfer of an entire business on a going-concern basis. However, as with all taxation issues, it is best to seek specific and tailored advice in respect of the particular facts and circumstances involved in each case, as the taxation position may vary accordingly.

Under the Income Tax Act, 1961, if shares are issued at a price that is higher than fair market value of such shares, the company issuing such shares will be taxed on the premium or excess amount. However, if a resident investor subscribes to or acquires shares of a company at a price that is lower than the fair market value of the shares, the investor will be taxed on the difference between such prices. While the conversion of securities into equity may be deemed taxable in the hands of the holder of such securities, Indian tax law specifically exempts the conversion of convertible debentures and convertible preference shares into equity shares from capital gains tax.

The Income Tax Act, 1961 states that all income accruing or arising, directly or indirectly, through or from any business connection in India, any property in India or any asset or source of income in India, or through the transfer of a capital asset situated in India, including shares in an Indian company, will be deemed ‘income accruing or arising in India’ for the purposes of the Indian tax laws. Such income is taxable in India as capital gains for both residents and non-residents. However, a non-resident who is a tax resident of a country with which India has a double taxation treaty may offset the tax paid in its country of residence against the tax payable in India for such capital gains. Generally, all foreign investors obtain tax advice in relation to the applicability of the Income Tax Act, 1961 and attempt to invest through an entity incorporated in a country with which India has a double taxation treaty.

Private equity investors will also seek indemnification from the target or the seller if a claim arises from the tax authorities for not withholding taxes from the consideration amount paid by the investor to the target or the seller. These tax indemnities must be carefully navigated by both parties – for instance:

• the investor must be adequately protected under the relevant investment agreement in the event that the investor may receive a demand notice from the tax authorities for any non-payment of taxes and penalties in relation thereto; and
• the target must protect itself with a limitation on its liability.

India has seen significant growth in various industries and offers start-ups certain exemptions and relaxations under law, which has led to an increase in the number of new businesses. As a result, the number of private equity firms and interested investors has also spiked over the last decade. However, in 2020, due to the onset of the COVID-19 pandemic and the potential worldwide economic depression as a result, business across industries have been impacted, which has also slowed down transaction processes and created uncertainty as regards the financial health of a target.

The prevailing issues for private equity investments in India are as follows:

• conducting thorough due diligence on targets and obtaining comprehensive representations and warranties;
• private equity firms being more involved in governance issues and in major decision-making activities of their portfolio companies;
• increasing interest in investing in stressed companies (strategic investments);
• increasing numbers of buyouts;
• increasing numbers of investments where limited partners invest along with general partners; and
• certain industries – such as technology-driven industries and e-commerce/retail businesses – being more attractive to investors.

We appear to be in a situation of oversupply of capital, with plenty of money being invested – the Jio and Reliance Retail mega ‘transaction-after-transactions’ are indicative of this trend. While this may mean that available opportunities or assets are overpriced, thereby reducing the spread that private equity investors would make over time, the opportunities in India for most investors are currently arising in consumer/consumption-driven industries and those leveraging digitisation. We are looking forward to greater investment interest in India in the consumer, education, medical and healthcare, financial technology and retail sectors, and a strong convergence in favour of online transactions.

During the COVID-19 pandemic, various exemptions from regulatory compliance were introduced for Indian companies, although these did not extend to investment transactions. They include:

• extension of the timeframe for convening annual shareholders’ meetings for the financial year 2022; and
• application of security clearance and consent from the Ministry of Home Affairs by any person who is a national of a country that shares a land border with India, seeking appointment as a director in an Indian company.

On 14 March 2022, the government, through Press Note 1 of 2022 Series, amended the Consolidated Foreign Direct Investment (FDI) Policy Circular of 2020. The key amendments made were:

• revision of the timeframe for Indian companies for repayment or conversion of a convertible note from five years as provided in the FDI Policy to 10 years from the date of issue of the convertible note; and
• issuance of ‘share-based employee benefits’ by companies in which foreign investment has been made under the automatic route. However, issuance of these share-based employee benefits requires the prior approval of the government. The addition of this new class of benefits may result in the grant of a number of benefits to employees of such companies.

While transactions arising from heightened private equity and venture capital interest, and more recently debt fund interest, in Indian industry continue to increase, the governance of such transactions is also changing as the industry grows. This includes regulations in relation to anti-competition, tax exemptions and benefits, and prohibition of stock manipulation. One would do well to consider sectors that have advanced significantly as a result of the COVID-19 pandemic and its regulatory and economic repercussions, such as robotics and automation, other deep technology initiatives, online education and education more broadly, healthcare and medical – all of which are now more relevant than ever before.

In closing, two specific aspects appear to impact on the maximisation of opportunities while managing potential issues or limitations in the Indian context:

• the need for both private equity investors and targets to manage more effectively, for their respective benefit, both the due diligence and the disclosure processes, in order to identify, address and contain or adjust pre-existing liabilities, and especially any pre-existing unknown risks that may subsequently arise; and
• the need to construct systems, processes and mechanisms within the target that promote growth while being mindful of good corporate governance and transparency in operations and outcomes, so as to unlock value in a way that is sensitive to all stakeholders, internally and externally, in the wider society and polity.

Additional Authors: Atul Lakshman, Rashi Dhariwal, Riya Agarwal, Vaishali Mishra and Harsha Tiwari.