PART
– 4.1
Foreign
Long Term Investors[1]
Investment by Foreign
Long Term Investors (FLTIs) refers to an investment made to acquire lasting or
long-term interest in enterprises operating outside of the economy of the
investor. There are strategic FLTIs and financial FLTIs.
Strategic
FLTIs
These investors are
operating companies that provide products or services and are often
competitors, suppliers or customers of investee companies. Their goal is to
identify companies whose products or services can synergistically integrate
with their existing product line to create incremental long-term shareholder
value. These investors actively participate in management of Investee Company.
Degree of participation in management depends upon extent of investment,
regulatory framework, and business considerations, for e.g. - if there is
complete buyout by these investors than the earlier board of the investee
company will get dismantle, and a new board will be constituted having
directors appointed by the strategic investors. A strategic investment may
result in:
· Wholly Owned Subsidiary (WOS);
· Joint Venture undertaking (JV), where an Indian investors setup new a new company with collaboration of foreign investors. For e.g. Vistara airlines is a JV between Tata sons and Singapore airlines; or
· Stake buy in an existing Indian company. For e.g. Etihad Airways bought 24% stake in Jet Airways.
· Wholly Owned Subsidiary (WOS);
· Joint Venture undertaking (JV), where an Indian investors setup new a new company with collaboration of foreign investors. For e.g. Vistara airlines is a JV between Tata sons and Singapore airlines; or
· Stake buy in an existing Indian company. For e.g. Etihad Airways bought 24% stake in Jet Airways.
Financial
FLTIs
These investors include
private equity firm, venture capital firms, hedge funds etc. These firms are in
the business of making investments in companies and realizing a return on their
investments. Their goal is to identify private companies with attractive future
growth opportunities and durable competitive advantages, invest capital, and
realize a return on their investment with a sale or an IPO. These investors,
like portfolio investors, are not interested in management’s affairs of the
investee company, but unlike portfolio investors, these investors can appoint
their representatives on the board of the company under investment agreement.
In case these investors choose to appoint their director/s on the board of the
investee company, he/they will not be actively participating in managements’
affairs of the company. Exit routes are extremely important for these
investors. After the expiry of the investment horizon, these investors will
encash their holding making huge capital gains on their initial investment. The
main source of ROI for these investors is in the form of capital appreciation,
whereas the profits earned by the company is the main source of ROI for
portfolio investors.
This distinction between
strategic and financial investors has major impact on the ways how FDI
transactions are structured. It has major impact on scope of due diligence,
terms and conditions of shareholders’ agreement etc. It will also help to
appreciate various provisions of foreign direct investment regime.
It would be worth noticing that in the life cycle of a company, strategic
investment comes after financial investment. Strategic buyout is most preferred
exit route for financial investors. Before strategic buyout of Whatsapp by
Facebook, there were venture capital investments in Whatsapp[2].
FOREIGN
DIRECT INVESTMENT SCHEME (FDI SCHEME)
Every year Department of
Industrial Policy and Promotion (DIPP) issues consolidated FDI policy. Schedule
1 to FEMA 20 contains mechanism to operationalise the FDI policy issued by
DIPP. There are automatic route and approval route through which FDI can come
into India. Under automatic route, there is no need to take prior approval from
govt. before receiving FDI and, in return, to issue equity shares or
convertible securities to foreign investors. Under approval route, there is
need to take approval from Foreign Investment Promotion Board (FIPB) before any
investment from foreign investors. FDI can result into two types of investment.
- · Greenfield Investment – Under this route, FDI results into setting up or expansion of business activities by the companies. There is a direct flow of money to the companies providing resources to expand or setting up of the businesses. FLTIs subscribe to unsubscribed capital of the companies, and, in return of investment, the companies issue fresh equity or convertible securities to the FLTIs. FLTIs may also get management rights to have a say in the matters related with the management of the company. All foreign direct investments by financial FLTIs result in Greenfield investment.
- · Brownfield Investment - Under this route, the existing shareholders sell their stake to FLTIs. Since, there is no fresh issue of securities by the companies to FLTIs, There is no fund flow to the companies enabling them to set up or expand business activities. Instead, promoters of the companies get money from FLTIs. FLTIs also get management rights through representation on the board of the company. Some foreign direct investments by strategic FLTIs may result in Brownfield investments. Strategic investment could also be hybrid i.e. strategic FLTIs can subscribe to the fresh share capital (Greenfield) and, at the same time, they can buy shares from existing shareholders (brownfield). Acquisition of Ranbaxy Laboratories by Daiichi Sankyo in 2008 was an example of strategic acquisition which was hybrid in nature. Daiichi purchased entire shareholding from promoters of Ranbaxy, and, at the same time, Ranbaxy issued additional shares and warrants to Daiichi.
Eligible Securities for FDI[3]
Indian companies can
issue following securities to receive FDI:
- · Equity shares;
- · Partly paid equity shares and warrants[4];
- · Fully, compulsorily and mandatorily convertible debentures (CCD);
- · Fully, compulsorily and mandatorily convertible preference shares (CCPS); and
- · American Depository Receipts (ADRs), Global Depository Receipts (GDRs), and Fully Compulsorily Convertible Bonds (FCCBs).
Non-convertible,
optionally convertible or partially convertible debentures and preference
shares will not be counted towards FDI, and the same will be treated as ECBs.
Strategic FLTIs prefer to
acquire equity shares to gain immediate control/active management rights over
the investee company. On the other hand, financial FLTIs prefer to acquire CCDs
and CCPSs so as to get preference over promoters of the investee company in
assets distributions in the event of winding up of the company. In early stages
of the companies, there is high risk of failure of the startups companies. To
contain the possible loss arising due to failure of the investee company,
financial FLTIs subscribe to CCPSs and CCDs.
1)
Listed
Companies – Generally, FDI in listed companies is in the nature
of strategic investment because these companies can easily raise funds from
other routes, and, also because, there is very limited scope of getting high
returns from capital appreciation in listed companies therefore these companies
are not investment’s target of financial FLTIs. FDI in these company can be
Greenfield or/and brownfield investment.
·
Private Investment in Public Equity (PIPE)
– As the term itself suggest, it is private investment in public company. In
company law and securities laws term, it is preferential allotment of specified
securities[6] regulated by ICDR
Regulations, 2009. Under this, companies issue fresh securities to foreign
investors (Greenfield). RBI mandates that pricing of securities in PIPE
transactions shall be done in accordance to the SEBI’s regulations i.e. pricing
guidelines of preferential allotment in ICDR regulations.
·
Transfer of shares (Brownfield) - The
price of shares transferred by way of sale shall not be less than the price at
which a preferential allotment of shares can be made under the SEBI Guidelines,
as applicable.
2)
Unlisted
Companies – FDI in unlisted companies can be both: strategic
and financial investment. For fresh issue of securities as well as transfer of
shares the valuation will be done as per any internationally accepted pricing
methodology for valuation of shares on arm’s length basis, duly certified by a
Chartered Accountant or a SEBI registered Merchant Banker.
Pricing of securities of listed companies has always been an easy
affair from regulatory point of view. RBI made SEBI’s pricing guidelines
applicable wherever the issue of pricing of securities of listed companies came
up. Pricing of securities of unlisted company saw changes of pricing
methodology. Earlier for issue and transfer of securities from resident to
non-resident under FDI, the prices of securities were determined on the basis
of Discounted Cash Flow (DCF) method. Now, the pricing can be done on the basis
of any internationally accepted pricing methodology. This gave more freedom of
negotiation to parties.
Optionality
Clauses while Issuing Securities
In financial management
terms, Options are derivative[7]. Options are traded on
F&O section of stock exchanges. FEMA is not concerned about their tradability,
but their impact on capital control mechanism. Generally, there are ‘call[8]’ and ‘put[9]’ options in shareholders' agreement. Call options are
used by strategic FLTIs to raise their holding in companies in future in
certain events such as if the sectoral caps of FDI have been raised by the
govt. than strategic investors would like to raise their holding to consolidate
their positions. Put options are used by the financial FLTIs as an exit route
after the expiry of investment horizon. Foreign investors by exercising put
options sell their shares to promoters of the investee company. These are put
options which faced regulatory frown in the past. RBI was of the view that
securities issued with put options gave investors assured returns which were
like debt financing and hence should come under much stricter regime of ECB.
But in January, 2014, RBI allowed issuance of securities with options subject
to certain conditions[10]. The emphasis of RBI was
to eliminate the scope of ‘assured return’. Circular issued by RBI ensures that
put options cannot be exercised atleast for a minimum period of one year. There
is a minimum lock-in period of one year or a minimum lock-in period as
prescribed under FDI Regulations, whichever is higher. The lock-in period shall
be effective from the date of allotment of such shares or convertible debentures.
Circular has prohibited
to issue securities with put options of which exercise price (not formula) has
been decided at the time of issue of securities. The exercise price of options
will be decided at the time of exercise of that options. The non-resident
investor shall be eligible to exit from the investment in equity shares,
Compulsorily Convertible Debentures (CCDs) and Compulsorily Convertible
Preference Shares (CCPS) of the unlisted investee
company at a price not exceeding that arrived at as per any internationally
accepted pricing methodology on arm’s length basis. The guiding principle would
be that the non-resident investor is not guaranteed any assured exit price at
the time of making such investment/agreements and shall exit at the fair price computed as above at the time
of exit, subject to lock-in period requirement, as applicable[11].
Exercise price of put options
to sell equity shares of listed companies
will be the prevailing price in stock market. The exercise price for
transferring CCD and CCPS issued by listed
companies will be a price worked out as per any internationally accepted
pricing methodology at the time of exit duly certified by a Chartered
Accountant or a SEBI registered Merchant Banker.
The regulatory regime on the pricing of options has been in state of flux since last few years. Initially, RBI
completely prohibited options in investment agreement, but in January, 2014, it
allowed the put options attached to equity
shares of unlisted companies to be exercised on the price determined as per
Return on Equity formula, which took away the element of assured return[12]. In July 2014, RBI again
changed its stance and gave more freedom to determine exercise price of options
attached to equity shares of unlisted companies to be fair price determined
according to any internationally accepted formula at arms-length basis. Now, in
January, 2015, RBI has allowed to Tata to pay pre-agreed price to DoCoMo. It is
highly recommended to read articles provided in footnote[13]. Regulatory regime for exercise
price of options attached to listed equity shares, CCD, and CCPS (of both
listed and unlisted companies) has been constant since RBI allowed options in
January, 2014.
Eligible
Foreign Investors
Investment under FDI
scheme is not regulated on the basis of classes of investors like under PI
scheme. Any non-resident entity can invest under FDI scheme. However, if the
origin of the entity is in Bangladesh or Pakistan than depending upon the
sector in which investment is to be made, approval from govt. has to be
obtained.
There exist considerable
ambiguity on the investment by FII under FDI scheme. As learned earlier that an
individual FII cannot hold maximum 10% of paid-up share capital of the company.
If an individual FII holds more than 10% of the paid-up share capital of a
company, than investment above 10% will be considered as FDI, and the same will
be counted toward FDI cap[14]. There may be a situation
in which a company requires funds, and a FII is willing to invest the money, it
can be done in the following ways:
- If individual FII’s holding is less than 10% - than the company can issue shares against the investment made by FII under private placement mechanism allowed under PIS in schedule 2 to FEMA 20. This can be done till the individual limit does not go beyond 10%.
- If Individual FII’s holding is at 10% - still the company can issue shares against the investment made by FII under private placement mechanism, but this will be done under FDI scheme and such investment will have same restriction as are applicable on FDI by any other non-resident Indian.
As noted in an earlier
part that FIIs can invest in unlisted companies under PIS in schedule 2 to FEMA
20. It was also noted that new RFPI regulations, 2014, prohibited investment in
unlisted companies under FPIS by FPIs. Now, both RFPI regulation and Schedule
2A to FEMA 20 stipulate that if FIIs do not exit the unlisted public company at
the time of listing of such company than investment under PIS will be
considered as FDI and the same will be subjected to capital control measures
under FDI scheme.
Composite
Sectoral Caps
As noted earlier,
investment in equity shares of a company can either be made under PIS or FDI
scheme. While under PIS, portfolio investors get only voting rights, but, under
FDI scheme, foreign investors may also get management rights besides voting
rights. In strategically important sectors such as banking, insurance, telecom
and real state, total foreign investment (PIS + FDI) cannot exceed sectoral
caps. Acquisition of voting rights is threshold for stricter regulation of
these sectors. In other sectors, investment under PIS and FDI scheme remains
separate, and investment in one scheme does not decrease the limit of investment
under other scheme. But in sectors with composite cap, investment under one
scheme will eat up the space of investment under other scheme.
This part has covered
various aspects relating to FLTIs under FDI scheme. There are various other
sector specific requirements in FDI policy.
Foreign Venture Capital Investors (FVCIs) has one other route to make
investment into Indian companies. This scheme is contained in schedule 6 to
FEMA 20. In next part (4.2), scheme for FVCI will be discussed.
[1]
The term is coined for the purpose of this article. FEMA regime does not
mention this term anywhere.
[2] Sequoia
Invests $8 Million In Messaging App Maker WhatsApp <http://techcrunch.com/2011/04/08/sequoia-whatsapp-funding/,
Last accessed at February, 14, 2015>
[3]
Consolidated FDI policy dated April, 17, 2014.
[4]
RBI/2014-15/123 A.P.(DIR Series) Circular No.3
[5]
RBI/2014-15/129 A. P. (DIR Series) Circular No. 4
[6]
Specified securities has been defined by ICDR Regulations, 2009 to mean equity
shares and securities convertible in equity shares.
[7] A
derivative is a contract between two parties which derives its value/price from
an underlying asset.
[8] A
call option confers a right on investor to buy shares in future.
[9] A
put option confer a right on investors to sell their shares in future.
[10]
RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86.
[11]
RBI/2014-15/129 A. P. (DIR Series) Circular No. 4
[12]
RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86.
[13] RBI
eases fair value buyout norm, allows Tatas to pay DoCoMo previously agreed
price for Tata Tele stake <
http://articles.economictimes.indiatimes.com/2015-01-14/news/58065915_1_tata-sons-ntt-docomo-central-bank/2,
Last accessed at February 14, 2015>
[14] Investment
by FIIs under the FDI route would not be reckoned towards the 10% limit
provided for investments under the FII route < http://www.indialawjournal.com/volume4/issue_2/special_report.html,
Last accessed at February, 13, 2015>
