India: Private Equity In India: The Risk, Structure And Reward

Last Updated: 4 March 2008
Article by William R. Kirschner and Yash A. Rana

With India's economy showing real GDP growth of 8.7% annually since 2003, international investments into India have increased significantly. Even as market conditions have limited private equity transactions in the United States and, to a certain extent, Europe, private equity investment in India totaled more than $10 billion for all of 2007. According to the Handbook of Statistics on the Indian Economy published by the Reserve Bank of India ("RBI"), overall foreign direct investment ("FDI") into India was almost US$20 billion for the 2006-07 fiscal year, more than double the 2006 figure of US$7.7 billion. And for 2007-08, some experts expect FDI to exceed US$30 billion. At this pace, FDI into India is likely to exceed that into China in the next two to three years, and rank India as the most favored emerging market for foreign investment.

Driving this growth in investment have been several prominent private equity firms, many of which have opened local offices in India. Goldman Sachs, Warburg Pincus, Blackstone and Carlyle, among others, have a significant local presence. Among the larger recent private equity transactions is the US$1 billion investment in Bharti Infratel by Goldman Sachs, Temasek Holdings, The Investment Corporation of Dubai, Macquarie, Citigroup and others in December 2007, along with an additional US$250 million by KKR in February 2008. TA Associates, Providence Equity Partners, Citigroup, GLG Partners, Sequoia and India-based ChrysCapital reportedly invested more than US$1 billion in Idea Cellular.

This dramatic increase coincides with the most difficult regulatory environment in India this decade. The RBI has sought to dampen inflationary pressures and a dramatic increase in the value of the Indian Rupee – which is not yet freely convertible on the capital account – relative to the USD and other currencies by restricting inflows of foreign capital into the country. In addition, as Indian political parties prepare for national elections before mid-2009, there has been considerable political posturing at the expense of the international investment community to woo important voting blocks, most notably the export-focused textile industry, that have been adversely affected by the relative increase in the value of the domestic currency.

The result of this economic, political and regulatory climate for offshore private equity investors has been dramatically increased valuations, particularly in the technology and real estate space, and reduction of flexibility on deal structures. India has long been a destination for minority investments. By contrast, control transactions and buyouts are not as common, with Goldman's US$230 million buyout of Sigma Electric in October 2007 being the largest buyout of the year. This is likely due to the prevalence of family-controlled businesses with a tradition of "passing on the business to my sons" and government restrictions on foreign Goodwin Procter LLP Page 2

ownership. While most business sectors in India now are open to 100% foreign ownership without prior regulatory approvals, the cultural impediments to buyouts persist.

Minority investments present structural challenges in the current regulatory environment. They offer limited downside protection, because optionally convertible "preference shares" (akin to preferred stock) and most optionally convertible debt structures (including USD denominated offerings) require prior regulatory approval. Accordingly, private equity investors typically make minority investments in the form of equity investments with put/call rights to existing shareholders (usually management, called "Promoters" in India) and buy-backs by the company over time. Mandatorily convertible preference shares and bonds also are used frequently, though redemption rights are limited. All of these mechanisms are subject to government-imposed pricing guidelines, which restrict arm's-length pricing and curtail downside protection.

Additionally, proper tax structuring in order to efficiently exit the investment is also critical. Taxation in India on capital gains can exceed 40%, and direct investments from many home country jurisdictions (including the United States) can expose foreign investors to the prospect of double taxation. Accordingly, investments are typically structured through tax favorable jurisdictions (currently, Mauritius, the Netherlands, Luxembourg and Singapore, among others). Investing through these jurisdictions also provides the greatest flexibility, as the regulatory hurdles diminish markedly in this context.

As the Indian economy continues its exceptional growth reflecting strong underlying fundamentals, we expect private equity investments in India to continue to increase dramatically. With careful attention to legal and tax structuring, investors should continue to see attractive returns on their investments.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2008 Goodwin Procter LLP. All rights reserved.

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