India Economy

Exit challenges for PEs

Zulfiqar Shivji | Updated on December 14, 2013 Published on December 14, 2013

Investments at higher valuations and a weak rupee are making private equity funds exit.

Private equity (PE) funds have been investing in India since the early 1990s. There was a U-shaped increase in their investments between 2006 and 2011. A significant amount of PE dollars were poured into the country in 2007 and 2008 (about $18 billion and $15 billion respectively) when India was rated the second best investment destination after China. PE funds contributed significantly towards funding newer business models, large infrastructure projects and M&A activity in the promoter-driven Indian economy.

But now, with typical historical fund life being 8 to 10 years, the investors’ much-loved destination has not provided an exciting exit experience.

While Alliance Tire Group gave multifold returns to Warburg Pincus, feuds between promoters and investors in kidswear, agri inputs, and real estate have compelled investors to move the courts for their rights, adding to exit woes. This could also have implications on new fund-raising.

During 2006-08, PE investors found Initial Public Offerings (IPOs) the best exit option. Jubilant FoodWorks is a case in point. However, since 2009, IPOs have fallen in popularity, with less than a fifth of companies wanting to list in India. This is a reflection of India’s uncertain economic outlook, weak investor sentiment and valuation issues. Under such circumstances, PE funds are evaluating listing in Singapore, Hong Kong or the UK.

The funds have also received a double whammy since they have invested at higher futuristic valuations and the rupee has declined sharply against the dollar. A large part of the capital was invested when the rupee hovered between 44 and 48 to a dollar. In dollar terms, the book value has eroded by over 25 per cent.

Tax issues

In an exit by way of secondary sale to another investor or promoters, tax withholding is proving to be one of the key negotiation points since tax authorities are trying to challenge treaty benefits in the absence of ‘real substance’ of companies situated in favourable tax jurisdictions. Buyers are trying to get protection against future tax demands by asking for advance rulings/certifications from tax departments, taking tax indemnities from the seller, drawing an insurance policy against future tax demands, or retaining the tax amount in escrow till the matter reaches finality.

Amendments introduced by the Finance Act 2013 are making it tough when it comes to exit by way of buy-back. The company buying back its shares would be liable to pay tax at 20 per cent for the difference between the original subscription price and the exit price. This adds to exit costs since investors banked upon the treaty benefits to almost eliminate the tax costs at the time of exit. This is also reducing the surplus available in the company while providing an exit opportunity to investors.

Other efforts

As a last resort, some PE investors obtained put options and buy-back rights coupled with a right to drag-along to ensure their exit. However these face a lot of practical challenges and are strongly resisted by promoters when exercised. Further, new investors may seek milestone based payments, expanding the investment time horizon further. Additional indemnities and warranties by new investors become a concern when the promoter or investee company does not receive any new money.

A recent announcement by the tax department characterising Cyprus as a ‘Notified Jurisdiction’ has left investors thinking again about their holding company/fund structures and evaluating strategies to move to another jurisdiction because according to the Department of Industrial Policy and Promotion (DIPP), Cyprus is rated within the top 10 countries investing in India.

Commercial issues in negotiating exits coupled with tax and regulatory challenges complicate planned/forced exit for PEs.

Such bottlenecks are also used by Indian promoters as arm-twisting mechanism to negotiate exit terms and play around valuations. But India still needs foreign capital to push forward its structural agenda. At the end of the first major PE investment cycle, a certain level of maturity should show up.

( The author is Partner BDO India LLP, an accountancy and advisory firm.)

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Published on December 14, 2013
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