Pursuant to the liberalisation of India’s foreign policies in 1991 married with the government’s fervent efforts to improve ease of doing business and introduce progressive reforms, India has emerged as an attractive investment destination. According to the 'India M&A Report 2019' published by Bain & Company in association with the Confederation of Indian Industry, India’s attractiveness as one of the fastest-growing large economies has resulted in a steady flow of inbound M&A, which surged from 9 per cent in 2015 to 20 per cent in 2018, with acquirers making acquisitions for India market entry being almost 1.5 times more likely to outperform their local indices.
However, because of market uncertainties caused by the covid-19 pandemic, one might expect to see changing landscapes of not just India M&A, but M&A globally. With the country already embarking on its journey to become self-reliant in a big push for the government’s ‘Make in India’ initiative, it remains to be seen how Indian policymaking adjusts to this new normal. Having said that, investors continue to show tremendous confidence in India even as global economies reel under the present dealmaking slowdowns. In May 2020, Jio Platforms Limited, the digital services arm of Reliance Industries Limited (RIL), has attracted investments worth US$10 billion from leading tech investors such as Facebook, KKR & Co, Silver Lake, Vista Equity Partners and General Atlantic, and is also reportedly in the process of negotiating another investment from one of the most valuable companies in the world.
Thus India M&A proves to be beneficial in many ways as India’s regulatory infrastructure offers multiple investment routes, with diverse categorisations, depending upon the nature of the investment vehicle used. This allows investors, both Indian and foreign, to tap into India’s fast-growing sectors through smart structuring strategies in order to realise their investment objectives. Some of these investment vehicles are discussed below.
Alternative investment funds
In recent times, the Indian alternative investment fund (AIF) sector has witnessed phenomenal growth trends. As per the statistics published by the stock market regulator, the Securities and Exchange Board of India (SEBI), the total funds raised by AIFs between 31 March 2018 and 31 December 2019 have doubled to a staggering 1.7 trillion Indian rupees. This is attributable to the conducive legislative reforms introduced by SEBI in 2017 pursuant to the recommendations made by the Alternative Investment Policy Advisory Committee under the chairmanship of the Indian IT mogul Narayana Murthy.
Prior to the notification of the SEBI (AIFs) Regulations 2012 (AIF Regulations), there was a paucity of comprehensive investment management regulations in the non-retail segment in India. Thus an urgent need was felt to recognise AIFs as a distinct asset class and appropriately regulate the various domestic funds in order to promote the fair and efficient functioning of the financial markets. It was in this background that the AIF Regulations came into force, in supersession of the SEBI (Venture Capital Funds) Regulations 1996.
AIFs and their categories
AIFs are defined to mean privately pooled investment vehicles that collect funds from investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of their investors, excluding funds operating in the retail segment such as mutual funds, collective investment schemes and other SEBI-regulated fund management activities.
In India, AIFs have the flexibility of being incorporated through different corporate structures such as companies, limited liability partnerships, bodies corporate and even as trusts (except family and employee welfare or gratuity trusts). Here, it is pertinent to note that since an AIF cannot make an invitation to the public at large to subscribe to its units or securities or partnership interest, as the case may be, its charter documents must necessarily prohibit it from making such invitation or solicitation to the public.
The AIF Regulations mandatorily require all AIFs to be registered with SEBI and procure a certificate of registration in order to carry on their investment activities. Entities desirous of being registered as AIFs may seek to be registered in one of the following three categories:
- Category I – for AIFs proposing to invest primarily in unlisted securities of startups or early stage ventures, social ventures, small and medium-sized enterprises, infrastructure or other sectors that the government or other regulators consider as socially or economically desirable. Category I AIFs are generally perceived to have positive spillover effects on the economy and may be eligible for incentives and concessions offered by the government or other regulators.
Category I AIFs must necessarily be close-ended (ie, units offered to investors by such AIFs must be for a limited period only and cannot be offered indeterminately). Further, such AIFs (including schemes launched by them) must have a minimum tenure of three years. Thus, on the expiry of its tenure, the AIF must necessarily be wound up in accordance with the AIF Regulations. Also, Category I AIFs are prohibited from borrowing funds, directly or indirectly, or engaging in any leverage, except for meeting temporary funding requirements that cannot exceed 30 days, on not more than four occasions per year, and cannot be more than 10 per cent of the AIF’s investible funds.
- Category II – for AIFs that fall neither under Category I or Category III, such as private equity funds or debt funds and for which no specific incentives or concessions are given by the government or other regulators. Like Category I AIFs, Category II AIFs also primarily invest in unlisted securities and are also subject to the same requirements, as set out above, in relation to their tenure and borrowing restrictions.
- Category III – for AIFs that undertake diverse or complex trading strategies and may employ leverage, including through investments in listed or unlisted companies, structured products and, since 21 June 2017, even in the commodity derivatives market on fulfilling certain conditions. A Category III AIF may engage in leveraging or borrowing subject to consent from its unitholders, provided that such leverage is not in excess of twice its net asset value. Further, unlike Category I and II AIFs, Category III AIFs need not adhere to any minimum tenure requirements. In other words, they may opt to be open-ended and offer their units to investors on a continual basis without any fixed maturity period. However, if Category III AIFs choose to be close-ended, then they will be required to comply with the tenure-related requirements of the AIF Regulations as elaborated above.
Thus, based on the foregoing, a prospective investor may choose to invest its funds by subscribing to units of whichever category of AIFs is suitable to its investment objectives. Additionally, it is also important to take into account certain other regulatory aspects of AIFs, as specified below.
Key regulatory aspects of AIFs Minimum corpus and investee companies
All AIFs, except angel funds, are required to have a minimum corpus of 200 million Indian rupees. Further, Category I and II AIFs cannot invest more than 25 per cent of their investible funds in one investee company, and Category III AIFs cannot invest more than 10 per cent of their investible funds in one investee company.
Minimum investments and maximum investors
AIFs cannot accept an investment value less than 10 million Indian rupees from an investor and cannot have more than 1,000 investors in the fund.
‘Flesh in the game’
The AIF Regulations have vested the sponsor or manager of an AIF with multifarious fiduciary obligations, with the mandatory continuing interest requirement being the most notable one. Thereby, the sponsor or manager of a Category I and II AIF is required to have a continuing interest of not less than 2.5 per cent of the corpus or 50 million Indian rupees, whichever is lower, as an investment in the AIF. In the case of Category III AIFs, such continuing interest of the sponsor or manager must be at least 5 per cent of the corpus or 100 million Indian rupees.
Since 2 July 2018, AIFs have been permitted to make investments abroad to the extent of US$750 million (as enhanced from the erstwhile limit of US$500 million), provided that AIFs desirous of making such offshore investments must inter alia submit their investment proposal in the specified format to SEBI for prior approval and make mandatory disclosures of utilisation of investment limits to SEBI. However, no separate permission from the Reserve Bank of India (RBI) is necessary in this regard.
Benefits of AIFs
With the AIF Regulations considering only those applicants eligible for registration that have an adequately experienced investment team and are fit and proper persons, AIFs are professionally managed investment vehicles. Further, all AIFs are required to adhere to high standards of transparency and make compulsory periodic disclosures to their investors in relation to the investment activities undertaken by them, including conflicts of interest. Therefore the AIF structure provides investors with the necessary comfort in relation to the proper management of their funds. In order to further enhance investor confidence in AIFs, SEBI regularly issues circulars to inter alia strengthen their stewardship responsibilities.
Moreover, Category I and II AIFs enjoy certain tax benefits under the Income Tax Act 1961 whereby any income (except income chargeable under the head ‘profits and gains of business and profession’) accrued to the investors from their investments in the aforementioned AIFs is taxed in the hands of the investors as if the investments made by the AIFs were directly made by the investors. This tax pass-through has made Category I and II AIFs increasingly popular since 2015. Additionally, where Category I and II AIFs acquire shares of a listed entity, they are exempt from paying securities transaction tax at the time of acquisition of shares to be able to take adantage of long-term capital gains tax exemption.
Notable acquisitions by AIFs
As per the latest report published by the Indian Private Equity and Venture Capital Association, the top investment involving AIFs in January to March 2020 was valued at US$567 million, whereby Varde Partners and Goldman Sachs (Category II AIF) acquired the debt of the distressed power producer, RattanIndia Power Limited, from its lenders. This acquisition is noteworthy on account of its being the biggest debt resolution transaction outside the Indian insolvency and bankruptcy framework without any change in the existing management and is the first successful scheme to have been closed under RBI’s Prudential Framework for Resolution of Stressed Assets. Further, the Indian ed-tech startup, Unacademy, raised US$110 million in its latest funding round from Facebook, General Atlantic, Blume Ventures (Category I AIF) and others. This has made Unacademy one of the highest valued ed-tech startups in India at a post-money valuation of US$510 million, after Byju’s, which is valued at US$8.2 billion. This will prove to be advantageous to the Indian education sector as the nation increasingly becomes dependent on e-learning portals not only on account of technological advancements, but also in the aftermath of the covid-19 pandemic.
Foreign portfolio investment
A foreign investor or a group of investors looking to invest in economies outside their own may explore entering the Indian securities market by seeking registration from SEBI as a foreign portfolio investor (FPI) in order to be able to acquire stocks and bonds of listed Indian entities. Unlike foreign direct investment (FDI), foreign portfolio investment is a short-term investment that is made by a foreign investor who is not involved in the day-to-day management of the investee company. These transactions are also referred to as portfolio investments, which form part of India’s capital account, and are shown on its balance of payments (ie, a calculation of the amount of money flowing from India to other countries in a financial year).
Sometimes, depending on market volatility, portfolio investments involve transactions in highly liquid securities (ie, securities which can be bought and sold very quickly). Thus foreign portfolio investment is affected by high rates of returns and reduction of risks through geographic divergence and exchange rates. This is evidenced by the fact that during the first three quarters of the financial year 2019–20, as per the data published on the website of the National Securities Depository Limited, India saw a considerable spike in its foreign portfolio investments, with a record high of approximately 230 billion Indian rupees in November, 2019, thereby making it one of the top emerging markets for FPIs. However, with the covid-19 pandemic leaving the world in disarray, an enormous number of FPIs pulled out their investments, with foreign portfolio investment in India falling in negative as of April 2020 and May 2020.
Foreign portfolio investment in the Indian capital market has been permitted for more than two decades, although under different nomenclature. Until 2014, portfolio investments were made by foreign institutional investors (FIIs) and qualified foreign investors (QFIs). Thereafter, in order to harmonise and simplify the various available routes for foreign portfolio investment in India, a new class of foreign investors, namely the FPIs, was introduced by SEBI by virtue of the SEBI (FPI) Regulations 2014 (2014 Regulations), which subsumed FIIs as well as QFIs within its ambit.
A need was felt to review, streamline and simplify the 2014 Regulations and therefore SEBI constituted a working group under the chairmanship of Harun Khan, retired deputy governor of the RBI. Pursuant to the recommendations of the group, the SEBI (FPI) Regulations 2019 (FPI Regulations) were notified on 23 September 2019 in supersession of the 2014 Regulations.
Key regulatory aspects of FPI Mandatory registration
As per the FPI Regulations, it is mandatory for an FPI to procure a certificate of registration from a designated depository participant on behalf of SEBI by applying either under Category I or Category II.
Category I comprises pension funds, university funds and appropriately regulated entities while Category II covers endowments, charitable organisations, corporate bodies, family offices, etc, which also includes appropriately regulated entities investing on behalf of their client. Moreover, the FPI Regulations have classified government and government-related investors such as central banks, sovereign wealth funds, international or multilateral organisations, including entities controlled by or having at least 75 per cent direct or indirect government or government related investor(s) ownership as Category I FPIs.
Here, it is important to mention that as per the Consolidated FDI Policy (last updated on 28 August 2017) issued by the Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry (FDI Policy), the FDI sectoral caps (ie, the maximum amount that can be invested by foreign investors in an entity), unless provided otherwise, subsume all types of foreign investments, including investments made by FPIs, subject to sector-specific conditionalities.
An overseas resident of India cannot apply for registration as an FPI. However, Indian residents, non-resident Indians (NRIs) and overseas citizens of India (OCIs) may be constituents of the applicant, subject to compliance with conditions specified by SEBI from time to time. In this regard, it has also been clarified that applicants or their underlying investors contributing 25 per cent or more in the corpus of the applicant or identified on the basis of control cannot inter alia be persons mentioned in the Sanctions List notified by the United Nations Security Council. Further, foreign central bank applicants will be eligible applicants even if they are not members of the Bank for International Settlements.
Permissible investments and other conditions
An FPI is permitted to invest in capital instruments such as shares, perpetual debt instruments, government securities, commercial papers, unlisted non-convertible debentures (subject to certain conditions), security receipts, derivatives, units of mutual funds, units of real estate investment trusts (REITs) and infrastructure investment trusts (InvITs), Indian depository receipts, interest rate swap, etc. Having said that, any unlisted holdings of FPIs are treated as FDI as per the FPI Regulations.
Further, offshore derivative instruments can be issued to, subscribed by or otherwise dealt with only by FPIs registered under Category I or by those entities having investment managers belonging to member countries of the Financial Action Task Force on Money Laundering.
As per the FPI Regulations, the total equity holding of a single FPI (including its investor group) is capped at 10 per cent of the total paid-up equity capital of an Indian entity, on a fully diluted basis. Further, under the Foreign Exchange Management (Non-debt Instruments) Rules 2019 (Non-Debt Rules), the aggregate equity holding of all FPIs put together, including any direct or indirect foreign investments in an Indian entity permitted under the Non-Debt Rules, is capped at 24 per cent of the total paid-up equity capital of the said entity on a fully diluted basis. Notwithstanding this aggregate investment limit of 24 per cent, the same may be increased, with prior approval of the board and shareholders of an Indian entity, up to the sectoral cap applicable to such entity as per the FDI Policy.
If an FPI exceeds the above-mentioned limits, in the absence of the requisite approval, the portfolio investment will be treated as FDI unless the investor divests the excess shareholding within five trading days from the date of settlement of the trades. Additionally, such investment will be calculated towards the sectoral cap and rules prescribed by the RBI from time to time and that particular FPI will no longer be permitted to deal in the securities of that specific Indian entity under the FPI route.
Thus the Finance Minister’s proposal in the Union Budget for 2019–20 to allow FPIs to invest in REITs and InvITs has found statutory recognition under the FPI Regulations. However, the proposal to increase the above-mentioned investment limits has not yet been implemented.
Benefits of FPI
From the point of view of a foreign investor, investing through the FPI route provides access to a bigger market as well as the flexibility to invest in sectors that may otherwise be prohibited for FDI. Further, this avenue involves less regulatory approval while dealing in securities and is generally a more efficient mode of secondary acquisition of listed securities. Wealthy investors with adequate holding capacity would view the falling prices of the Indian securities as an opportunity to buy in bulk at a much lower price and earn higher returns by selling the securities as soon as the prices begin to rise. On the other hand, higher inflow of foreign portfolio investment not only aids in boosting the Indian capital market but also helps the equity prices to positively reflect the value of the Indian entity.
Notable acquisition by an FPI
China’s central bank, the People’s Bank of China (PBOC), raising its stake to 1.01 per cent in India’s largest housing finance lender, the Housing Development Finance Corporation Limited (HDFC), made headlines in April 2020 and arguably induced the government to revise its FDI policy (as discussed below). The PBOC now holds around 17.5 million equity shares of HDFC worth approximately 30 billion Indian rupees.
Foreign direct investment
Like all other developing countries and developing markets that thrive on foreign investments, India has been consistently taking steps and introducing norms to attract FDI. From 2000 until December 2019 the FDI inflow into the country totalled US$65 billion, and between April 2019 and December 2019 India snagged approximately US$3.6 billion through FDI.
The legal framework regulating and governing FDI is laid down under the FDI Policy and the Foreign Exchange Management Act 1999 (FEMA) (including relevant rules, regulations, circulars, etc issued thereunder). As per the Non-Debt Rules, FDI means investment through equity instruments by a person resident outside India in an unlisted Indian company, or in 10 per cent or more of the post-issue paid-up equity capital on a fully diluted basis of a listed Indian company.
Key regulatory aspects for FDI Restrictions on FDI from neighbouring countries
With effect from 22 April 2020, prior permission of the government of India is required for investment by an entity of a country sharing a land border with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country. Additionally, in the case of any transfer of ownership of existing or future FDI in an Indian entity, directly or indirectly, resulting in the beneficial ownership being in the hands of citizens of such bordering countries, such subsequent change in beneficial ownership will also require governmental approval.
FDI is expressly prohibited in the following sectors:
- lottery business including government or private lottery, online lotteries, gambling and betting including casinos, etc (including foreign technology collaborations);
- chit funds;
- Nidhi company;
- trading in transferable development rights;
- real estate business or construction of farm houses;
- manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes; and
- atomic energy and railway operations (not open for private investment).
With respect to non-prohibited sectors, foreign investors will have to adhere to the sectoral caps and FDI-linked performance conditions, if any, before investing in Indian entities.
Investment by non-residents
According to the Non-Debt Rules, any investment made by a person resident outside India on a repatriable basis in equity instruments of an Indian company or towards the capital contribution of a limited liability partnership (LLP) is considered as foreign investment. Hence, non-resident entities looking to tap into the Indian market and seeking to establish a long-term interest may invest in Indian companies or LLPs in accordance with, inter alia, the FDI Policy, Non-Debt Rules, Companies Act 2013 (Companies Act), Limited Liability Partnership Act 2008 (LLP Act), SEBI regulations in case of FDI in listed entities and the Competition Act 2002 (Competition Act).
Investment by NRIs and OCIs
NRIs and OCIs may invest in an Indian company or contribute to the capital of an Indian LLP on either a non-repatriable or repatriable basis. If investment by NRIs and OCIs in Indian entities is on a non-repatriable basis, this will be considered as domestic investment.
FDI in an Indian company
As per the Non-Debt Rules, non-resident entities are permitted to invest in equity instruments (through subscription, purchase or sale) of an unlisted Indian company or, in the case of listed Indian companies, invest 10 per cent or more in its equity capital, subject to compliance with the Companies Act, SEBI Regulations and the Competition Act. Enumerated below are various modes through which a non-resident entity may acquire a stake in an Indian company:
An acquisition by any person resident outside India of equity instruments issued by an Indian company must be in compliance with the FDI Policy, FEMA laws including pricing guidelines, sectoral caps, prior government approvals (if applicable), entry restrictions, reporting requirements and such other conditions as maybe specified by the central government from time to time.
Persons resident outside India may also subscribe to partly paid shares or share warrants issued by Indian companies. According to the Non-Debt Rules, Indian companies can issue partly paid shares to a person resident outside India that must be fully called up within 12 months of such issue or as per such time period specified by the RBI. However, 25 per cent of the total consideration amount of such partly paid shares (including share premium) must be paid upfront. Similarly, in the case of issuance of share warrants, at least 25 per cent of the consideration must be paid upfront and the balance amount within 18 months of such issuance.
Any transfer of equity instruments between persons resident outside India and persons resident in India should adhere to the sectoral caps, pricing guidelines and other conditionalities as set out under the Non-Debt Rules and the FDI Policy. Additionally, such transfer can be on a deferred consideration basis (subject to the total consideration being based on the pricing guidelines prescribed by the Non-Debt Rules) such that an amount not exceeding 25 per cent of the total consideration may be:
- paid by a non-resident buyer on a deferred basis within a period not exceeding 18 months from the date of the transfer agreement;
- settled through an escrow arrangement between a non-resident buyer and a resident seller for a period not exceeding 18 months from the date of the transfer agreement; or
- indemnified by the resident seller for a period not exceeding 18 months from the date of the payment of the full consideration, if the total consideration has been paid by the non-resident buyer to the resident seller.
The Companies Act permits mergers and amalgamations between companies incorporated in India and companies established in foreign jurisdictions, provided the foreign company may, with the prior approval of the RBI, merge into an Indian company or vice versa. Accordingly, the RBI issued the Foreign Exchange Management (Cross Border Merger) Regulations 2018 to govern and regulate cross-border mergers.
FDI through joint ventures
Foreign investors may also partner with strategic Indian partners to build and expand their scope of business in India through a joint venture, subject to entry route restrictions, sectoral caps and conditionalities, pricing guidelines, etc as identified under the FDI Policy and the Non-Debt Rules.
FDI in an Indian startup
According to the Non-Debt Rules, a person resident outside India, other than an individual who is citizen of Pakistan or Bangladesh or an entity that is registered or incorporated in Pakistan or Bangladesh, can purchase convertible notes issued by an Indian startup company for an amount of 2.5 million Indian rupees or more in a single tranche. An NRI or an OCI may acquire convertible notes on non-repatriable basis without any limit. Also, such investment in convertible notes by a person resident outside India will require the prior permission of the government of India, if the startup company falls within the sector that requires such approval. Further, a person resident outside India may acquire or transfer by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the entry routes and pricing guidelines.
If the convertible notes are converted into equity shares, then issuance of such equity shares must be in accordance with the relevant entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment applicable to India.
FDI in an Indian LLP
An LLP is another form of investment vehicle that non-resident entities may consider for the purposes of FDI. As per the FEMA laws, subject to the provisions of the LLP Act, any person resident outside India (except citizens of Pakistan or Bangladesh and entities incorporated in these countries) is permitted to invest by way of either capital contribution or acquisition or transfer of profit shares of an LLP in sectors where 100 per cent FDI is permitted through the automatic route and there are no sector-specific FDI conditions. However, FPIs and foreign venture capital investors are not permitted to invest in an LLP.
Foreign investors looking to invest in an LLP will be required to ensure that their investment is not less than the fair market price as determined by the valuation norms prescribed by the Non-Debt Rules. However, in the case of transfer of capital contribution or profit share from a person resident outside India to an Indian resident, the transfer consideration cannot exceed the fair market price.
Benefits of the FDI route
In the recent past, India has greatly relaxed its FDI norms (including further liberalisation of sectors such as contract mining, single-brand retail, civil aviation, etc) with a view to facilitating ease of doing business for foreign and domestic players. FDI in India can boost the Indian economy as, inter alia, it promotes access to advanced technologies and technical know-how, provides a gateway to global platforms, employment opportunities, higher capital inflow, etc.
Notable M&A deals
The India M&A landscape has many noteworthy deals involving FDI. For instance, Walmart’s acquisition of Flipkart in 2018, for a enormous US$16 billion, was the world’s biggest purchase of an e-commerce company and is India’s largest acquisition in the retail sector. Further, in 2019, the takeover of Essar Steel by ArcelorMittal Nippon Steel India Limited for US$7 billion was one of the largest M&A deals within the Indian insolvency and bankruptcy framework. Additionally, the acquisition by Canadian investment firm Brookfield Asset Management Inc (Brookfield) of RIL’s telecom tower assets for approximately US$3.66 billion was one of India’s biggest private equity deals.
In light of the foregoing, it is pertinent to note that while India has robust inbound M&A opportunities, acquisitions by domestic companies have a significant impact on India M&A. In this context, we must mention the contentious hostile takeover of Mindtree Limited by Larsen and Toubro Limited in 2019, valued at approximately 107 billion Indian rupees, which was the first of its kind in the information technology sector. This takeover is also a testament to the fact that acquirers (including foreign investors complying with the extant investment limits) as persons acting in concert may, directly or indirectly, cooperate with other shareholders in order to fulfil the common objective of acquiring shares, voting rights or exercising control over the listed Indian entity, subject to compliance with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011.
On one hand, while the Indian regulatory sphere allows resident entities to explore diverse structures through companies, LLPs, joint ventures and trusts to acquire a stake in other Indian entities, these broad-based norms as applicable to them may not always be applicable to foreign investors. This is because India is an exchange-controlled regime, with the entry into certain sectors being highly regulated, if not prohibited. Having said this, by employing the smart structures discussed in this chapter, investors may make successful investments and positively partake in India’s growth story. This can be seen from the strong foothold that Brookfield has in India, with its aggregate investments in 2019 amounting to approximately US$6.2 billion.