Exit momentum is typically considered as a determinant indicator of investors' confidence in the market. While the year 2018 saw a surge in exits in the private equity (PE) space, the recent slump in the Indian economy has put exit opportunities on hold in the first half of calendar 2019. The exit trends during the calendar 2018 indicated that Indian markets had started showing signs of achieving maturity, however the slowdown in the economy coupled with rising liquidity concerns has triggered a spurt among PE investors seeking alternative exit options. We could therefore expect investors to either adopt a wait-and-watch approach in anticipation of a revival of the Indian public market or possibly move towards strategic negotiated sales to monetise their investments. Data from several studies indicate that PE exits have recorded stake sales worth just $3.1 billion in the first half of calendar 2019 as against $33 billion in calendar 2018 across a total of 265 deals, on account of traditional sectors like consumer and financial services having witnessed subdued exit activity.
In this article, we discuss the key considerations that would need to be borne in mind for actual implementation of the preferred (and viable) exit options, typically considered by PE houses.
Common Modes of Exit
Exits are of central importance to PE investors and they consider a variety of different exit strategies to realise their return on investment. Some of the most common PE exit strategies include:
- Initial Public Offer (IPO): Volatility in public markets has dampened some PE-backed public offerings, but learnings from recent IPOs1 suggest that exits through public markets continue to remain lucrative for PE investors.
- Trade Sale and Third Party Sale: This has been a primary driver for increasing interest of PE investors in 'control-deals' for their ability to determine their investment horizon and their preferred mode of exit, independent of promoter intervention. While public offers continue to remain the most preferred mode for exits by several PE houses, instances of strategic exits have shot up recently. Examples include sale by Norwest Venture Partners of its interest from its Indian portfolio at an expected 3X return, and the exit proposed by IAG from SBI General Insurance through a secondary sale to Warburg Pincus and Premji Invest.
- Dual-track Process: PE firms sometimes also utilise a 'dual-track process' to exit their investments, ie filing a prospectus for IPO and simultaneously exploring opportunities for a secondary sale. Dual-track process offers the PE investors with an opportunity to test the water in the public market, while simultaneously looking for a suitable strategic purchaser.
- Leveraged Recapitalisation: This is a partial exit strategy that allows a PE investor to monetise its investments without necessarily selling the company.
- Merger with listed company: Another exit route that is sometimes used by PE investors is via a merger of the unlisted investee company with a listed company. However, given the regulatory uncertainty and the significant time delay that a tribunal driven merger process entails, this exit mode is sparingly used.
Other Key Considerations and Trends
- Preparing the Portfolio Company for Sale: Being financial investors with an investment philosophy of generating returns on their investments, PE investors usually (especially as they approach their investment horizon) keep regular tab on the performance of the company and are involved in strategic decisions which may impact valuation. Further, as part of the 'clean-up' of a portfolio company before its impending sale, another emerging trend is to refinance or repay the existing debt of the company (all or substantially all) to be able to inter alia: (i) showcase a strong balance sheet to potential incoming buyers; and (ii) procure release of encumbrances, if any, over shares of other shareholders which may be relevant for a bulk sale.
- Partial Exit: In case of a partial exit, retaining a majority stake or control rights of a listed company may also expose the PE investor to the risk of being classified as a promoter or 'co-promoter'. Partial exits from private companies come with the risk of the PE investor being unable to stay in the driver's seat and piggybacking on the exit strategy employed by the founders / promoters of such company.
- Use of Insurance Product: Most PE investments are routed through funds which have a limited fund life and internal restrictions around accepting wide ranging indemnity obligations including uncapped indemnities. As such, a viable alternative for exit which is fast gaining popularity is the use of an insurance product to enhance, and in some cases, entirely replace the indemnification framework that sellers may provide in such transactions.
- Locked-box v Completion Accounts: Broadly, there are 2 ways of effecting post-completion adjustments, ie, by using completion accounts or a locked-box mechanism. In the Indian context, traditionally, adjustments by using completion accounts were difficult to achieve and a locked-box mechanism was rarely used. With deferral of consideration (up to stipulated time) and monetary limits now being permitted, post-closing adjustments within such limits can be undertaken. A locked-box mechanism is typically viewed as being more seller-friendly, given that it entails certainty in pricing and saves considerable management time and effort, which would have been expended otherwise in preparation of completion accounts. That said, in a locked-box mechanism, the negotiated post-signing interest to be paid along with the purchase price may not be sufficient to offset the impact of interim actions which would be factored in completion accounts.
- Severance Payouts or Compensation Arrangements: A PE investor, as part of its exit strategy from a listed company, cannot enter into compensation or profit-sharing arrangements (including arrangements for severance payouts) with the promoters, directors or key employees, to incentivise them by sharing returns beyond a hurdle rate, without approval of the board and non-interested public shareholders.
- Other Regulatory Considerations: India being a regulated economy with the movement of foreign exchange being closely monitored, there are several other regulatory considerations in relation to exits, such as pricing restrictions for transfers between residents and non-residents, limited post-closing adjustments being permissible without prior government approval and filing requirements. That said, foreign venture capital investors registered with the Securities and Exchange Board of India are exempt from entry and exit pricing guidelines. Separately, the parties should also evaluate anti-trust issues and potential anti-trust filings, if certain specified thresholds are met or if the transaction is likely to have an appreciable adverse effect on competition in India.
- Guaranteed Returns: Whether a foreign investor's exit option can be at a pre-determined valuation, thereby guaranteeing assured returns has been the subject matter of much debate. Developing jurisprudence (NTT Docomo Inc v Tata Sons Limited and Cruz City 1 Mauritius Holdings v Unitech Limited ) is indicative of a greater willingness on part of Indian Courts to enforce damages' and indemnity claims even where the underlying contractual obligation is in breach of Indian exchange control restrictions on guaranteed returns.
- Tax Considerations: There may be several tax considerations as well depending on the cost of acquisition of shares and the difference with the final sale price. Care should be taken to ensure that indemnity payments, if any, are not viewed as income and are instead adjusted as capital gains, to avoid additional tax impact. Further, exit structures must be effected to minimise tax exposure do not fall foul of Indian 'general anti-avoidance rules'. In transactions involving the sale of shares by a non-resident PE investor to another non-resident PE investor, indemnities for any indirect transfer taxes (including pursuant to amendments introduced in DTAAs with countries such as Mauritius, Singapore and Cyprus) also become a vital component of the share purchase agreements.
- Enforceability of IPO provisions: Given that IPO offer documents are signed by all the directors of the company, the fiduciary duties of directors may not permit the company to undertake an IPO on terms prescribed by PE investors if the directors feel that the IPO is not in the best interests of shareholders. Further, the company must have a track record of profitability and net worth, and minimum net tangible assets, etc. As such, the enforceability of IPO provisions in shareholders' agreements remain largely untested.
One key determinant to assess investor confidence in a market is the exit impetus and the driving trends for an exit. PE investors in the sectors of consumer technology, IT and ITES, banking, financial services, insurance and software-as-a-service (SaaS) have garnered the highest returns during the last few years thereby generating most of the exit values.
Several studies suggest that exits which have not been as successful were primarily on account of management issues and macroeconomic headwinds, and keen buyers and strong management teams stood as major stimulus to successful exits. To maximise value, PE investors would need to keep updating their exit playbooks to build and monitor value-creation with more rigour to tap any exit opportunity that presents itself in the more than ever dynamic Indian economy.
That said, it remains to be seen how the Indian PE space will adapt itself in the wake of current market conditions and the growing stress on companies to maintain and justify high valuations, which is imperative for PE investors to book their profits. While India stands a bit afar from a mature exit market, one can remain hopeful of exits in PE space to soon rally.
1. IPO by Aavas Financers Limited, the offer for sale by Tata Opportunities Fund in the initial public offering of Varroc Engineering Limited and the offer for sale by TA Associates in TCNS Clothing Company Limited.
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