The high influx of PE houses in India in the past few years, coupled with an increase in the deal volumes, have kept the deal-makers teasing their brains to overcome several challenges in handling deals in India. But in spite of the usual specifications of executing deals with closely held promoter groups in India, deal-makers have been successful in structuring deals through the regulatory maze to achieve their objectives.
A typical term sheet signed by a PE house contains, among other ingredients, a ‘re-up’ clause which enables the PE Investor to take an increased stake in the Indian target company at a future point in time.
The ‘re-up’ clause basically includes a mechanism whereby a nominal stake is initially acquired by the PE investor. The term sheet would then contain a provision which would entitle the PE investor of a higher equity stake in future as the company’s progresses. This higher equity stake would be a direct outcome of the EBIDTA levels achieved by the company. This acts as a catalyst to achieve a win-win situation for all the stake holders. Thus, in a typical PE deal there is a desired shareholding pattern which is completely dependent on the performance of the company.
Besides the ‘re-up’, PE funds also look at a flexible mechanism to ensure smooth exits in future.
One of the traditional ways of structuring deals to achieve the above objectives is by injecting appropriate call and put options on investment instruments. Such options give sufficient flexibility, so as to achieve the desired shareholding at a future point in time with minimum leakages and frictions.
The Reserve Bank of India has endorsed its intention to have simple equity instruments without any inbuilt options. In its recent policy announcement (consolidated FDI Policy effective from October 1, 2011), it is enshrined in the regulations that only equity shares, compulsorily convertible debentures and compulsorily convertible preference shares with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non-residents, having in-built options or supported by options sold by third parties, would lose their equity character and such instruments would have to comply with the extant ECB guidelines.
Thus, it is clearly evident that all equity shares, which are issued or transferred after October 1, 2011, will have to be decoupled with any inbuilt option of any type. Otherwise, the investments will be regarded as an External Commercial Borrowing (ECB) and will have to comply with the highly restrictive ECB guidelines. This policy change substantially narrows the structuring avenues available on deals. The implications on existing and future deals on account of this policy change can be significant and may act as a road-blocker unless the deal is minutely structured to meet pre-set objectives.
Given the recent developments including the policy changes announced like the one above, it is clearly evident that the regulator prefers vanilla structures as opposed to complex arrangements and terms while inviting foreign investment in India.
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