PE and strategic investments in India: referee v/s jury

By Zulfiqar Shivji

  • 02 Jan 2014

Performance of PE investments in India has been a mixed bag at best. PE investments, which really took off in 2004 and 2005 and peaked in 2007 at $ 17.1 billion, have been coming in at a steady pace but have not grown thereafter. In 2012 the new PE and venture fund investments were $10.2 billion.

In the initial phase major investment were in financial services and IT. A number of them were in well governed corporate space like HDFC, Shriram, Bharti, Kotak, Genpact and ICICI. Investors made healthy returns in these investments due to growth in the economy and well managed entities.

Economic turbulence, uncertainty about regulations, quality of governance and a slow and weak legal system are some of the key challenges impacting the PE and VC landscape. Unlike in developed economies where PE funds take over majority control and management of corporate entities with leverage, India allows them to take strategic minority stake. A major change in the trend has also been a fall in the average deal size from $ 28 million in 2011 to $18 million in 2012. The number of early stage deals under $10 million in size has been in excess of 200. This is not surprising since the quest of small businesses and start-ups for capital and the desire of investors to catch them early to maximise returns.


Normally the investments are made with a typical shareholder’s agreement (SHA) with affirmative or negative voting rights in critical decisions, board seats, agreed business plan and right to information. Alternate Dispute Resolution mechanism are agreed to overcome the hurdles of legal system.

While going is good, most investors rely on above checks and balances to satisfy themselves that the conduct of business is in line with their expectations in terms of performance, governance and legalities. They depend on nominee directors, management and statutory auditors for oversight and information.

In the normal course of events, these are reasonable safeguards likely to provide normal and concurrent information to investor. However, small and new start ups in unlisted space suffer from inherent limitations on MIS and governance. Many of them are either unable or unwilling to lift themselves up to a level which is conducive to a healthy partnership.


Nominee directors and local representatives of investors may over a period of time develop faith and trust in the management and lack professional skepticism. They may lack knowledge of regulatory issues. Information provided by management may be motivated, biased or even misleading. Statutory auditor’s scope of work is limited in more than one way. Apart from information that is likely to be available in normal course of statutory audit, they may not or need not look further.

Investigations and internal audits are normally commissioned when there is a real or potential dispute between the parties. By that time both the parties are very alert to the consequences. Information flow may be subject to the advice of the lawyers. Fact finding may itself become the subject matter of a dispute.

A classic example is the case of Lilliput Kids Wear; Bain Capital and TPG had invested $86 million for a 45% stake in this company in March 2010. About 18 months later, disputes arose between the investors and the promoter. The Delhi high court appointed an independent auditor for the company. After co-operating initially, the promoter went back to the court saying the auditor is going too far. Ultimately high court referred the audit dispute to an arbitration tribunal.


It is pertinent to mention that investors had seats on the board and accounts were audited by a reputed international firm of auditors as statutory auditor.

There are similar disputes in the real estate space involving reputed developers where project delays, overruns and markets have stretched PE players closer to their redemption timelines with no visible exit in sight.

On the other hand, investors and the local promoters may agree to a periodic or a mid-tern diligence of the business by an independent entity. This diligence should cover business performance vis-à-vis business plan, review of material legal compliances, potential red flags on corruption related issues, decision making and corporate governance issues in the context of SHA, and validation of information provided to investors.


Draft findings of the report should be transparently shared with the management. Final report after taking into account the comments of the management should be submitted to the board and IC.

This approach will give an opportunity to the senior management of the investor and investee to be alert to issues impacting their relationship. It will also provide an opportunity to make suitable corrections before it is too late. It may also help the investor make or curtail additional commitments to the business. Last but not the least, it may nip a number of potential disputes in the bud.

(Zulfiqar Shivji, Partner and Head, Transaction Advisory & Support in BDO India LLP.)


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