By Abhijeet Sonawane and Bhanudey Singh Kanwar

Venture capital and private equity fundshave the advantage of not only infusing an entrepreneurial enterprise with funds but also of ensuringthat the enterprise is managed efficiently. As such,VCs oversee the systemicstability of ventures by ensuring market efficiency, formation of new capital and adherence to applicable laws.Investment opportunities are typically found in starts ups as well as in distressed enterprises. In India, however, venture capital fundsin both areas are burdened by a wide range of restrictive laws and regulations. The Securities and Exchange Board of India (“SEBI”), the securities market regulator in India, acting under authority of the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”)lays down the regulations governing the investment of venture capital funds.

The general trend among venture capital funds has been to invest in profit generating companies/projects. However, in recent times the Indian economy has alsowitnessed a significantrising interestin investment in non-performing assets. For example, funds have sought alternative investments, such asleveraged buy-outs (LBO) of distressed enterprises. Such investments are funded by bank borrowings collateralized by the assets of the bought-out distressed enterprise. Some argue that by restructuring and restoring distressed enterprises to health, the LBO model helps the economy as a whole, especially in a developing country like India. Others counter that LBOs are ultimately corrosive to the development of the economy as a whole because of the harsh measures imposed upon targeted firms in the process of restructuring them. The possibility of what it sees asdiversion of borrowed funds into non-performing firms has been of concern to India’s central bank, the Reserve Bank of India (RBI) because of fears that such excessive and somewhat speculative lending by banks for LBOs could put a severe strainon the overall health of the Indian economy.

The RBI has sought to recognize and address the root causes of what it sees as dangerous new trend into non-performing assets. The concern is based on the fact that banks play a significant role in the Indian economy when it comes to corporate borrowing. As a result, Indian law currently preventsventure capital funds from making investments in leveragedbuy-outs, which is a globally accepted model. Specifically, Indian regulations prohibit investment of funds procured by taking loans from banks/financial institutions that are collateralized by the assets of the investee company. There are signs, however, that the RBI may be reconsidering its position regarding LBOs. In December 2013, the RBI released a Discussion Paper on “Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalizing Distressed Assets in the Economy.“The Discussion Paperintroduces the concept of the regulatedleveragedbuy-outto India.

LEVERAGED BUY-OUTS IN INDIA

Globally, in a leveraged buyout (“LBO”) the objective is to acquire an undertaking without infusing considerable capital. Rather, the aim is to utilize the assets of the target undertaking as collateralto secure a loan from banks/financial institution to finance the acquisition. The Discussion Paper, in its current form,introduces the LBO model of investments as a way to revitalize sick/distressed companies.It proposes to liberalize the regulatory treatment of asset sales by allowing LBOs for specialized types “stressed companies”. The LBO model initially would allow funds and sector specific companies to play an active role in revitalizing the stressed assets market.

PREVAILING RESTRICTIONS IN INDIA

Venture capital fundsfacethe following restrictionsunder the prevailing laws in India:

• To protect the interests of domestic companies, the RBI prohibits banks and financial institutions from granting loans for acquisition of shares in any Indian company. However, domestic banks are allowed to advance loans to Indian companies for acquisition of shares in foreign joint ventures and wholly owned subsidiaries, subject to certain conditions as may be prescribed by RBI.
• The Foreign Investment Promotion Board (FIPB), the apex authority regulating foreign direct investment in India, prohibits investors from acquiring loans from domestic banks for acquisition of shares in an Indian company.
• AIF Regulations also restrict funds from acquiring loans directly or indirectly from banks/financial institutions or to engage in any form of leverage, except for meeting temporary funding requirements for a time period not exceeding 30 days, for a maximum of four occasions in a year, and not for more than ten percent of the corpus.
• Section 67(2) of the Companies Act, 2013 which came into effect on April 1, 2014, restricts public companies from providing any financial assistance to a person for the purpose of or in connection with a purchase/acquisition of its shares. Further,companiesare restricted from providing any guarantee, loan or any security of any nature to an investor whether directly or indirectly.

In view of these restrictions, mostventure capital funds areweighed down with a barrage of regulatory and compliance requirementsthat arenot in sync with the model prevalent in other developed economies.If the LBO model is ever introduced in India, the regulatory restrictions will need to be suitably amended for it to be successful.

Moreover, the Indian Venture Capital Association (IVCA), an association,established to promote the development of venture capital funds in India,though active,is not active enough to adequately represent a large proportion of the fundsthat are seeking investment opportunities in India. A more pro-active role played by IVCA to promote development of funds would provide them with opportunities that would support entrepreneurial activity and development.

LEVERAGED BUY-OUTS IN THE U.S.

By comparison, U.S. laws provide much greater leeway to venture capital funds. The LBO model in U.S. is governed byfederal securities laws and regulations such as theSecurities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. Venture capital funds are also governed by the regulations promulgated by the Securities and Exchange Commission (SEC).

U.S. lawspermit the LBO model by not imposing the kinds of prohibitions, restrictions or regulations seen in India. U.S. laws focus on transparency and accountability. The U.S. experience has shown that LBOs have benefited target or “investee” companies and are not as harmful as Indian regulators seem to believe.

HOPE FOR REGULATORY REFORM

The corporate and financial sector in India supports deregulation and is eager to be permitted to use the LBO model of investmentby securing loans from foreign institutionswhen investingoutsideIndia.The LBO model is particularly appealing given that the corporate debt market in India is also constrained by regulatory restrictions. As a consequence, most major fundsin India tend to look for opportunities in investor-friendly countries which have favorable regulationsand are more conducive LBO and other alternative investment modelsthe laws of the U.S.are also conducive for investment in start-ups and small scale industries. By contrast, the prevailing laws in India for start-ups, and the small/medium scale industries are yet to match U.S. or global standards.

Despite India’s drawbacks, there is a ray of hope for the LBO model given that the Discussion Paper proposes allowing it in India. The LBO model as proposed in the Discussion Paper is restricted to stressed companies alone. It would help if the proposal were all-encompassingso as address the needs of all stakeholders. This would include creating an environment to limit protracted litigation which only acts as yet another roadblock in making investment decisions.Nonetheless, the RBI through the Discussion Paper has shown a willingness to reconsider its opposition to the LBO model in India. Permitting LBOs would invite foreign investments and also ensure that the economy is not burdened by distressed assets and unavailability of capital.

As distressed assets are an immediate concern for the recovery of the Indian economy, the RBI has been wiseto review its initial opposition to LBOs andto test their suitability in India, albeit in a restricted manner. A loosening of the regulatory restrictions on LBOs would encourage funds to invest in them thereby making them more cost effective and attractive.

LBOs have been successful in U.S.Once allowed, how effective they will be in India remains to be seen.

Abhijeet Sonawane, is a Senior Associate and Team Leader at Hariani & Co., Mumbai. He has about 8 years of experience in corporate advisory and transactions. He can be reached at abhijeet.sonawane@hariani.co.in.

Bhanudey Singh Kanwar is an Associate at Hariani & Co., Mumbai handling and assisting in matters pertaining to general corporate advisory. He can be reached at bhanudey.kanwar@hariani.co.in.

The authors wish to acknowledge and thank Sourav Roy for his assistance in the preparation of this article.