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This article is written by Anant Roy pursuing a Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management at Lawsikho. This article has been edited by Ojuswi (Associate, Lawsikho). 

This article has been published by Sneha Mahawar.

Introduction

Private Equity (PE) and Venture Capital (VC) investments are showing significant growth every year. This is not just because of technological advancement and innovations but also because of a regime of prudent regulations which govern these investments. Since both the PE and VC investments are private placements, confusion with regard to their governing regulation always exists. To end the very confusion this article tries to differentiate between both PE and VC investments from a regulatory standpoint. In the end, the article also discusses a few precedents which have acted as catalysts for such investments.

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What are Private Equity (PE) and Venture Capital (VC) Investments

Both forms of investments are private investments i.e., private investors make the investments in exchange for equity which provides ownership to the investor in the investee company. The major difference between PE and VC is in the intentions of the investors and in the type of company the investment is to be made.

PE investors invest in mature or well-established private companies. With this type of investment, the investor aims to buy majority stakes or all stakes in a company and will have a say in the operations of the company. This means the investors get the right to sell the company to make profits. This type of investment is made when the growth of the company is stagnant though the company might have a well-established business. One of the most significant PE buyouts in India was PE firm Carlyle buying majority stakes of Hexaware Technologies, a deal worth $3 billion.

VC investors invest in companies that are in the nascent stage with a high potential to grow. With this type of investment, the investors buy minority stakes in the company to get high returns in the future. This type of investment is usually taken by companies to have an industry expert onboard who could help the company grow. Here the majority stakes of the company are with the promoters hence the decision-making powers are in the hands of the promoters. This type of investment is riskier as the investment is made by looking at the possible prospects of the company. In India, VC investments are majorly made in Fintech, Software as service companies, and E-Commerce.

The question is there any difference between the VC and PE investment from a regulatory standpoint? To answer that some Indian regulations which govern both Indian and foreign PE and VC investment are discussed below. 

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Laws and regulations pertaining to private equity and venture capital in India

What we understand from the paragraphs above is that private equity is the umbrella whereas, Venture Capital investment is a type of private equity investment that focuses on smaller companies with high growth potential. But, is there any difference from a regulatory standpoint? 

In India, both PE and VC investments are regulated by the Securities Exchange Board of India (Alternative Investment Funds) Regulation, 2012 accompanied by the Companies Act, 2013 and the rules there.     

The Securities Exchange Board of India (Alternative Investment Funds) Regulation, 2012 

An Alternative Investment Fund (AIF) is a fund incorporated in India in the form of a trust, limited liability partnership (LLP) or body corporate, where the funds are collected from private investors. These funds shall not be covered under the Securities Exchange Board of India (Mutual Fund) Regulation, 1996 and Securities Exchange Board of India (Collective Investment Scheme) Regulations, 1999 or any other regulation of the board to manage funds. 

It has divided types of investments into three categories: 

  • Category I AIFs – These are investments that are made in start-ups or early staged companies, which also include venture capital funds, Small and Medium-Sized Enterprise (SME) funds. Recently, social impact funds and special situation funds were added to this category.
  • Category II AIFs – Any kind of investment which does not fall in Category I or III AIFs shall fall under Category II. 
  • Category-III AIFs – These funds use complex trading strategies and can invest equally in both listed and unlisted investee companies.

The explanation of both categories I and II clarifies that category-I includes Venture Capital funds and Category II includes Private Equity funds. Hence, from a regulatory perspective for domestic funds, there is a slight difference between both types of investments. Accordingly, there are different conditions applicable to both investments. While category-III is different from the other two categories. It involves investment in listed companies, short-term return, high risk and higher regulatory compliances. In domestic private equity investments, there are some conditions imposed on both PE funds and VC funds, which creates a small difference between the investments.    

Conditions and restrictions for Category-I (VC) and Category-II (PE) AIFs

Since both investments are made through private placement there are many similar regulations. Both the categories of AIFs shall have a minimum corpus of at least rupees twenty crores and with each investor investing not less than rupees one crore.  Also, in both the AIFs investment can be taken from resident, non-resident and foreign investors. Further, the sponsors shall have an investment in the AIF of a minimum of 2.5% of the corpus or rupees 5 crores, whichever is lower. The AIFs shall not have more than a thousand investors and shall not invite public investment and funds should be collected only through private placement. Both the categories of investment are close-ended funds with a minimum tenure of three years. Both categories shall invest not more than 25% of their investable funds. 

There are some mandates which are different for both categories. For category-I AIFs, investment can be made in the investee company, venture capital undertaking, special purpose vehicles, LLP and in the units of category-I AIFs of the same subcategory or the units of Category-II AIFs. Whereas category-II AIFs can invest in any investee company or units of category-I or II.

Further, a VC fund shall invest 75% of its investable fund in unlisted equity or equity of venture capital undertakings or listed or unlisted Small and Medium Enterprises (SME) on SME Exchange. Whereas, category-II AIF or a private equity fund shall primarily invest in unlisted companies or invest in other AIFs of category-I or II. Since it is not specified how much investment is to be mandatorily made in unlisted equity, Category-II AIFs have a larger scope to invest in listed companies. 

Foreign investment in private equity and venture capital undertakings 

In India, foreign private investment is regulated by different regulations. Both PE and VC investments have separate regulations. For example, PE investments are regulated by the annually issued FDI policy and Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.  Whereas, foreign VC investments are regulated by SEBI (Foreign Venture Capital Investment) Regulations 2000. Let’s dive deeper into the intricacies of both regulations.

Foreign Private Equity investment

In India, foreign investment in private equity is governed by the annually issued Foreign Direct Investment (FDI) policy, which is regulated by Foreign Exchange Management (Non-debt Instrument) rules, 2019. 

As per the recent consolidated FDI policy 2020, FDI means investment through capital instruments by a person resident outside India in an unlisted Indian company. Further, there are two routes through which foreign private investment is allowed in India, the Government route and the Automatic route. In the Government route, a foreign investor needs approval from the Reserve Bank of India (RBI) or the Central Government. For Example, in the Print media industry, only 26% of FDI is allowed through the government route and 46% of FDI is allowed in the broadcasting industry through the government route. Whereas, in the Automatic route, no such approval is required. For example, in the pharmaceutical industry 100% FDI is allowed through an automatic route, telecom services 100% FDI is allowed. Also, there are some sectors that are prohibited from any foreign investment. For example, Atomic Energy, Railways, Lottery, Chit funds, etc.     

Foreign Venture Capital 

For a foreign venture capital investor to invest in any VC undertaking in India or VC fund registered under SEBI (Alternate Investment Fund) Regulation, 2012, it has to register itself with the board. 

Further, there are a few mandatory conditions for a foreign VC investor. The Foreign VC investor shall disclose the investment strategy to the board. It shall invest in only one VC fund or AIF. A foreign VC investor must invest 66.67% of investable funds in unlisted equity, the remaining 33.33% can be invested in the IPO of a VC undertaking, debt instrument of a VC undertaking or preferential allotments of equity shares of a listed company.

Further, foreign VC investors are subjected to inspections, which can be initiated on a Suo moto or on receiving any complaint regarding any default by the board. If after the inspection, the foreign VC investor is found with any default then the board may cancel the registration of the foreign VC investor.

Judicial pronouncements 

In India, judicial interventions are usually prolonged and sometimes end with verdicts that do not promote businesses. This is why companies try to avoid all sorts of judicial intervention and try to resolve disputes through outside court resolution. But sometimes disputes end up in courts. In the recent past, Indian courts have given pro-Business decisions. Some of such judgments are discussed below.

Edelweiss Financial Service Ltd. v. Percept Finserve Pvt. Ltd. and Anr.

In this case, Edelweiss got into a Share Purchase Agreement (SPA) with Percept where Edelweiss bought some shares of Percept. The SPA contained a put-option clause that allowed Edelweiss to re-sell the shares to Percept in breach of certain conditions. Edelweiss claimed a breach of those conditions under the SPA and wanted to exercise the put option. But Percept denied all the allegations of breach of conditions under the SPA and refused to comply with the put-option.

The arbitral award was in favour of percept and it was held that the put-option clause was a forward contract which is prohibited under Section 16 of the Securities Contract (Regulation) Act, 1956. The award was further challenged in the Bombay high court. 

The court decided that put-option is not a forward contract because both the delivery of shares and payment of the price is done simultaneously. The court also referred to its judgment in MCX Stock Exchange Ltd. v. SEBI, where it was held that put-options are not a forward contract. 

Though a proper clarification from the Supreme Court of India or the regulators is awaited, these judgments of the Bombay High Court have laid a foundation for the jurisprudence of the put-option clause in a SPA, which is a good exit strategy for investors. 

NTT Docomo INC v. Tata Sons Limited

As we know businesses avoid judicial interventions in dispute resolution and always look forward to arbitration as their primary dispute resolution mechanism. In this case, Docomo and Tata approached the London Court of International Arbitration (LCIA).  The award was passed in favour of Docomo and damages were awarded to Docomo which were to be paid by Tata.  

Later, Docomo approached the Delhi High court for enforcement of the decree, where RBI intervened and contended that since the award was in violation of FEMA regulations the award cannot be enforced. The court held that RBI did not have any locus standi in opposing the arbitral award and compromise between the two parties. This judgment not just acts as a precedent for recognition of foreign arbitral awards by Indian courts but also lays down that third-party intervention in arbitral awards is not permissible, even if the third party is a regulatory body.

Conclusion     

Indian regulations for PE and VC investments are quite similar. But, still, there is a lot of overlapping which does not allow you to completely distinguish between both. For example, the FDI policy is issued by the Department of Promotion of Industry and Internal Trade (DPIIT) and it only talks about private placements in Indian companies by foreign investors, but it also applies to any foreign VC investor who wants to invest in India through foreign VC investments are governed by a separate regulation issued by SEBI. This overlapping is hard to mitigate because of the fact that both investments are private investments.

Reference

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