This article has been written by Devesh Sharma, a final year law student at UPES, Dehradun.
Abstract:
This article delves into the intricacies of India’s corporate laws and exchange control regulations, with a focus on capital structuring and profit distribution under the Companies Act of 2013 and its amendments. It outlines the hurdles faced by private equity (PE) and venture capital (VC) investors as they navigate India’s complex regulatory landscape. The article also examines the role of the Securities and Exchange Board of India (SEBI) in regulating Alternative Investment Funds (AIFs) and the evolving investment environment for PE and VC in the country. Key regulatory milestones, including SEBI’s AIF Regulations of 2012 and guidance from the Reserve Bank of India (RBI), are discussed in relation to their impact on foreign investment in AIFs. The conclusion underscores the importance of legal expertise to effectively navigate these regulations, particularly for structuring PE and VC transactions in India’s dynamic business environment.
Key words: Corporate laws, Exchange control regulations, Private equity (PE), Venture capital (VC), Alternative Investment Funds (AIFs), SEBI regulations, foreign investment.
Introduction:
India’s corporate laws and exchange control regulations have long been known for being complex, especially in two key areas for private equity and venture capital investments: capital structuring and profit distribution. The Ministry of Corporate Affairs (MCA) introduced new rules (the “Rules”) to enforce the Companies Act of 2013 (the “new law”), which have unfortunately made these issues even more difficult.
The new law replaces the Companies Act of 1956 (the “old law”) and aims to enhance corporate governance, regulate companies more effectively, and prevent corporate fraud. It introduces several important changes, such as requiring more companies to appoint independent directors, setting clear duties and qualifications for directors, and tightening regulations on related party transactions. While the intention behind the new law is to modernize and improve corporate law in India, many of its problems lie in its implementation.
The MCA has been given broad powers to create rules for the new law’s enforcement, but several provisions in these Rules are seen as overly detailed, restrictive, and at times illogical. The areas of capital structuring and profit distribution highlight these issues well. Despite the new law’s potential, its complicated implementation has created further challenges.[1]
Regulatory Oversight of Alternative Investment Funds (AIFs) in India
The main regulatory body overseeing alternative investment funds (AIFs) in India is the Securities and Exchange Board of India (SEBI). AIFs must register with SEBI before they can start accepting investments and operating. SEBI, established under the SEBI Act of 1992, regulates the securities market in India. While the manager of an AIF does not need to register separately with SEBI, they are still governed by SEBI under the SEBI (Alternative Investment Funds) Regulations 2012.
SEBI has the authority, based on the SEBI Act and AIF Regulations, to inspect AIFs’ financial records and documents. This inspection is done to ensure compliance with the AIF Regulations, address investor complaints, and check that records are kept correctly. SEBI can also conduct searches, seize assets, impose penalties, and issue orders against the AIF and its manager.
In addition, AIFs and their managers that are set up as limited liability partnerships or companies are also regulated by the Registrar of Companies under their specific laws.[2]
Adapting Private Equity for India’s Growing Market and Regulatory Challenges
Between 2010 and 2014, private equity (PE) and venture capital investments in India grew at an impressive annual rate of 20%. The reasons for this growth are clear. India offers strong growth potential, supported by a stable political and legal environment. Additionally, the country is experiencing a rise in its middle-class consumers, along with rapid urbanization and digitalization, making it an attractive market for investors.[3]
Despite global economic challenges and uncertainty, India has recently stood out as a leader among emerging markets. With economic liberalization that began 25 years ago and the potential for further reforms, India’s dynamic economy offers a promising opportunity for private equity (PE) funds. PE funds have been optimistic about India and continue to invest heavily. In 2015 alone, they invested a record USD 16.8 billion in the country.[4]
One of the most notable aspects of private equity (PE) activity in India has been the way PE firms have adjusted their traditional approach, commonly used in the U.S. and Europe, to fit India’s legal and regulatory framework. As one expert observed, “While the traditional PE model worked well in developed economies, PE firms quickly realized it wouldn’t be easy to apply the same model in India due to various legal restrictions.”[5] To overcome these challenges, PE firms in India created an alternative model tailored to the country’s complex regulatory and governance environment. This shift highlights the limitations of India’s regulatory system for PE funds.
Challenges in Capital Structuring for Growing Companies Under New Indian Laws
For new and growing companies seeking to attract investment, having flexibility in structuring capital is crucial to reflect the risks and rewards agreed upon with investors. These companies are usually privately owned by experienced shareholders. Investors often prefer to structure profits in a way that follows a “waterfall” system, where different priorities are set based on the amount of available cash for distribution. Voting rights for investors and founders may also differ depending on the decisions being made.
The new law allows Indian companies to issue equity shares with different rights regarding dividends, voting, or other matters, which is key for structuring a “waterfall.” However, the Rules place strict conditions on issuing these shares, making it difficult for companies to do so. Unlike the old law, which exempted private companies from similar restrictions, the Rules now apply to all companies. Two specific conditions particularly hinder the ability to structure a typical “waterfall.”
First, the Rules limit shares with differential rights to 26% of the total post-issue paid-up equity share capital. This becomes problematic because the amount invested by investors is usually based on the company’s valuation, which is much higher than its paid-up share capital. As a result, the 26% limit severely restricts the ability to grant investors shares with differential rights. The reasoning behind this limit, especially for private companies, is unclear.[6]
Secondly, the Rules state that only companies with a consistent track record of three years of distributable profits can issue shares with differential rights. However, many companies that are prime candidates for private equity and venture capital investments are likely to have losses, as they are in the early stages of growth and are reinvesting in their expansion. This rule prevents these companies from securing crucial investments, which may only be possible under such terms. Once again, the reason for this restriction is unclear.[7]
Key considerations in structuring venture capital funds in India
The Indian government occasionally introduces regulations to boost investments. Before establishing a Venture Capital Fund (VCF), there were many factors to consider, which often caused confusion. As a result, many other investment funds were using the VCF structure because the person creating the fund had to first choose what type of investment fund they wanted. This made it difficult for the government to support innovation, entrepreneurship, growing businesses, and the start-up ecosystem. To address this, new regulations were introduced in 2012.
The Securities and Exchange Board of India (SEBI) implemented the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations), recognizing VCFs as a separate asset class. These regulations aimed to make investing easier and helped establish AIFs as a popular investment option. Key changes included:
- Exempting AIFs from a lock-in period for shares during an Initial Public Offering (IPO);
- Providing more clarity on the tax classification of AIFs;
- Allowing foreign capital invested in AIFs to be treated as domestic capital if the fund manager is domestically owned and controlled. This means the AIF is not subject to pricing guidelines and sectoral limits under Foreign Direct Investment (FDI) rules.[8]
The biggest challenges faced by venture capital investors
Venture capital (VC) investments are not for the faint-hearted. The VC sector is highly competitive, with investors constantly competing to find the next successful startup or “unicorn.” With an industry average where three out of four venture-backed startups fail, the risks have never been higher.
Competition is a constant in almost every industry, and venture capital is no different. A common frustration among venture capitalists is the feeling that they are often not the first choice compared to bigger players in the field.
Start-up overvaluation is becoming more common than it once was. With the rapid growth of technology, the number of emerging startups and potential unicorns has skyrocketed. However, many of these so-called unicorns turn out to be unrealistic, much like the mythical creatures they are named after. These companies often fail to live up to their inflated valuations once they enter the competitive market. Overvaluation poses a significant risk to future profits and should be avoided.
One of the major challenges venture capital firms’ faces is the lack of clear information about the performance of their portfolios. Although several software solutions have been developed to improve portfolio reporting, they are still not perfect. Additionally, venture capital investments face other hurdles, such as the constant need to raise more funds and secure profitable deals.[9]
Recent Developments
The 2013 Act, which took effect in 2014, was created to significantly update India’s old company laws from the 1956 Act and enhance corporate governance. The 1956 Act made a clear distinction between private companies, which were less regulated because they were small and closely held, and public companies, which had more shareholders and required stricter regulations. However, the 2013 Act blurred this line and imposed heavier compliance requirements on private companies.
Since Indian company law doesn’t allow private companies to sell their securities to the general public, they raise capital by issuing securities to a limited number of chosen individuals through a process called “private placement.” Since private equity (PE) funds often invest through private placements, understanding this process is crucial for successful transactions.[10]
Alternative Investment Funds (AIFs) are regulated investment vehicles in India overseen by SEBI. Since their introduction four years ago, AIFs have experienced considerable success. While AIFs can be structured as companies, trusts, or limited liability partnerships, they are typically set up as trusts for certain tax advantages.
Initially, FEMA did not clearly allow foreign investments in trust structures, leading to uncertainty for both private equity (PE) fund sponsors and investors, known as limited partners (LPs). There was also confusion about whether AIFs that pooled foreign capital would count as downstream foreign investments.
In 2015, the Reserve Bank of India (RBI) addressed these concerns by explicitly permitting foreign investments in AIFs without needing RBI approval. It further clarified that investments made by AIFs would not be classified as downstream foreign investments, provided that neither the AIF’s sponsor nor its investment manager is controlled or owned by non-residents. This development is highly beneficial for the Indian AIF industry, as it simplifies the process of raising funds from foreign LPs.
Conclusion
As global markets become more competitive, selecting the right people to lead and manage new projects, along with securing funding, is crucial. Indian venture capitalists have created more growth opportunities in the economy. Key sectors, such as pharmaceuticals, information technology, and various services, are now open to venture capital investment. As a result, venture capitalists are actively seeking business opportunities and have become a main source of funding for innovative entrepreneurs, providing essential support for their growth.[11]
It’s been 25 years since India opened its economy, yet we still see frequent changes to the commercial laws that govern business and private equity (PE) transactions. Although all political parties have remained committed to gradually liberalizing the economy, India has faced criticism for the slow pace of reforms and the rapid changes in regulations.
Given this mix of growth opportunities and shifting regulations, the role of Indian transactional lawyers has become extremely important. Today, lawyers handling PE deals must navigate a constantly changing regulatory and tax landscape to protect their clients from potential negative impacts. Therefore, it is crucial to regularly review established legal principles and market practices when structuring a PE deal in India.[12]
[1] Nandan Nelivigi, India’s New Corporate Law: Challenges in Structuring Private Equity Investments (Aug. 20, 2014), https://www.globalprivatecapital.org/app/uploads/2017/03/Indias-New-Corporate-Law.pdf.
[2] Khaitan & Co, In brief: regulation of private equity funds in India, March 9 2024
[3] Aparna Sheth, Madhur Singhal & Pankaj Taneja, Indian Private Equity Report 2015, BAIN & COMPANY, INC. AND THE INDIAN PRIVATE EQUITY & VENTURE CAPITAL ASSOCIATION, https://bit. ly/lQkoZcS.
[4] Indian Private Equity Trend Report 2016, Venture Intelligence, https://bit.ly/28SjUqS.
[5] Afra Afsharipour, The Indian Private Equity Model, NSE WORKING PAPER WP/8/2013 2 (2013).
[6] Nandan Nelivigi, India’s New Corporate Law: Challenges in Structuring Private Equity Investments (Aug. 20, 2014), https://www.globalprivatecapital.org/app/uploads/2017/03/Indias-New-Corporate-Law.pdf.
[7] Ibid
[8] King, The Legal Framework of Venture Capital Investment in India, (Feb. 24, 2023), https://www.mondaq.com/india/financial-services/1286482/the-legal-framework-of-venture-capital-investment-in-india.
[9] Ibid
[10] Recent Developments in Indian Law: Impact on Private Equity Transactions, https://repository.nls.ac.in/cgi/viewcontent.cgi?article=1137&context=nlsir.
[11] King, The Legal Framework of Venture Capital Investment in India, (Feb. 24, 2023), https://www.mondaq.com/india/financial-services/1286482/the-legal-framework-of-venture-capital-investment-in-india.
[12] Recent Developments in Indian Law: Impact on Private Equity Transactions, https://repository.nls.ac.in/cgi/viewcontent.cgi?article=1137&context=nlsir.
