PRIVATE EQUITY FUNDING AND ITS LEGAL ASPECTS

GLIMPSE:

These days news headlines of economic newspapers are clustered with a number of investment striking deals where you come across the words, phrases and abbreviations like a buyout, takeovers, fundraisings, M&A, PE, VC, and so on. All of nowhere these words flashing seem to be tricky jargons. In this article we will be understanding about PE or Private Equity, what it is, how it works and about its legal aspects.

Private equity is a concept which has finance as well as legal frame attached to it. Private equity is a type of corporate investment wherein Investors or bunch of investors invest in shares of the entity which are not listed on stock exchanges, help such entities grow and resell them at a profit. These investments are usually made by private equity firms, venture capital firms, or angel investors.  Leveraged buyouts, venture capital (VC), growth capital, distressed investments and mezzanine capital are some subsets of Private equity Fundings.

  1. Concept of PE:

Companies need funds to run their business. Public limited companies can call for capital and deposits from general Public. However, The provisions of the Companies Act, 2013 do not give the same leverage to Private Companies. Thus, there are few sources left for fund raising. Here private equity helps them in funding their operations. A private equity firm is a pool of money intending to invest in private companies. PE firms raise money from limited partners (LPs). LPs often include university endowments, pension funds, capital from other companies, Wealthy individuals, etc. General partners (GPs) of the PE firm are the ones who manage the money from the LPs and The day-to-day operations of the firm, making investment decisions and managing the acquired companies. PE firms get their consideration by charging an annual management fee of 2 to 3 percent of the money under management and then taking carry of the profits when they sell portfolio companies. Most often, the PE firm’s compensation is 20 percent. The LPs get their original investment back plus 80 percent of the profits.

Thus, PE functions in a way where there is a win-win situation for both- the company (as they get long-term funding) as well as the investors (as they get a share in profits) who contribute towards the funds.

Laws regulating PE:

Private Equity investment can be done by Venture Capital firms, Private Equity firms, Angel Investors, etc. As such, the legal or regulatory framework of venture capital and private equity firms is very similar.  However, the difference is when the investment is from the overseas investors and whether the target company is private limited or public limited company.

COMPANIES ACT,2103:

In order to safeguard their investment, private equity investors usually nominate one non-executive director to the board of the target company. The Companies Act 2013 has significantly expanded the duties and liabilities of non-executive directors who do not take part in a company’s day-to-day activities thus, exposing them to liabilities. PE investors appointing nominee directors to boards of portfolio companies are required to comply with the provision of the Companies Act, 2013. As per the provisions of the act, PE fund’s nominee director must procure a director identification number, should not be a person being an undischarged insolvent or a person being convicted by a court for any offence involving moral turpitude or others. From the perspective of a PE investor, corporate governance and disclosure rules are set out either in shareholders’ agreements or the charter documents, or both, in case of investments in private companies which ensure greater flexibility in prescribing strict governance norms.

 

Where a Company is willing to raise funds through private placement of securities, the provisions of Section 42 need to be complied with. Also, PE investments made by way of preference shares need to comply with Section 55 of the Act. Further, the Act restricts investments through more than 2 layers of investment subsidiaries and requires the companies to amend their Articles in this regard.

SEBI Act, 1992 and the Regulations thereunder:

A PE fund is usually established in the Form of a trust (as under the INDIAN TRUST ACT, 1882.) However, it is registered (it is compulsory to get registered with SEBI) as an Alternate Investment Fund under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. These regulations apply to all PE investment funds registered in India which receive capital from Indian or foreign investors. The Alternative Investment Funds (AIFs) have been categorized into three classes viz. Category I, Category II and Category III. PE Funds belong to Category II (these funds are allowed to invest anywhere in any combination, but cannot take debts, except for day-to-day operation purposes.) The regulations further impose certain restrictions on any scheme from having more than 1000 investors and further accepting a deposit of less than 1 Crore. Further, to regulate investments from overseas Investors, SEBI announced the SEBI (Foreign Venture Capital Investor) Regulations, 2000 (“FVCI Regulations”) enabling foreign venture capital and private equity investors to register with it through the registration under the Regulations are not mandatory, but it makes them eligible to avail of certain benefits provided thereunder.

Foreign Direct Investment Policy:

Issued by the Department of Industrial Policy and Promotion from time to time, FDI Policy regulates the inflow of FDI in India and further imposes general conditions and sector-specific conditions on these investments. There are two types of routes for Investments coming as FDI which are mentioned in the policy as the Automatic Route and the Government Approval Route. In case the investment falls under the automatic route, no permissions and approvals need to be taken by the investor, however, if the same falls under the government route then due permissions need to be taken.

FEMA AND RBI Regulations:

Foreign investment in India is governed by   Section 3, 4 and  6 of the Foreign Exchange Management Act, 1999. Further Foreign Investment by non-resident in resident entities through transfer or issue of security to a person resident outside India is a ‘Capital account transaction’ and is regulated under Foreign Exchange Management Regulations. A SEBI registered Foreign Venture Capital Investor (FVCI) with specific approval from RBI under FEMA Regulations can invest in Indian Venture Capital Fund (IVCF) provided that the VCF should also be registered with SEBI.

Tax Laws:

A private equity fund set up as a Category I or Category II AIF will enjoy pass-through taxation, that is, the income is not taxed at the AIF level but shall be chargeable to tax directly in the hands of its investors (exempt from tax under section 10 (23FB) and section 10 (23FBA) is with respect to incomes other than business income). Business income of an AIF is taxable at applicable rates and is exempt in the hands of the unit holder. There are no specific tax exemptions available to FVCIs. The purpose of the sections 10(23FB) and 115U is to make venture capital funds and companies tax-exempt and to provide for the taxation of the income in the hands of the investors when distributed to them. Further, investors can plan tax benefits if they route their investments from more favorable jurisdictions with whom, India has signed  Double Taxation Avoidance Agreement. FVCI investing through a tax treaty jurisdiction can avail benefits under the tax treaty.

This post has been contributed by Mr.Kunal Chandriani. He is pursuing B.Com(T.Y.B.Com) from Gurukul College of Commerce, Mumbai.

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L&P Editorial Team

The Law & Practice Blog's editorial team.

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