[Hrithik is a student at National Law School of India University, Bangalore.]
India is in the midst of a crisis in the banking sector – non-performing assets (NPAs) with their heads under the water. The RBI, in its report, asserted that the gross NPA ratio was 6.9% in September 2021 and the absolute value of bad loans was at INR 8.37 lakh crore. This is after banks wrote off bad loans of more than INR 2 lakh crores. COVID-19 also contributed to the decline in lending. For a healthy economy, funds need to be pumped into start-ups and mature business companies.
Private equity, a massive success in the West, is garnering significant traction in India. Due to regulatory environment, companies are being coerced to divest their assets and resulting in attraction of considerable private equity interest. However, the Indian legal landscape brings in a lot of barriers to the achievement of full potential of private equity. One such barrier is the practical impossibility of leveraged buy-outs (LBO) in India.
In this piece, I argue in two prongs that the legal barriers to LBOs should be obviated to allow for better approach to the NPA problem. First, I delineate the general functioning of LBOs, which unlock the keys to the NPA crisis. Second, I pose the present legal regime and how it encumbers any possible LBO.
LBO – The Ideology and its Traction in the West
In the West, private equity’s dramatic growth was attributed to aggressive use of debt. A key mechanism in this story has been leveraged buyouts. In an LBO, the investor finances the acquisition of the portfolio company through both debt and equity. The investor ensures that she herself does not commit a huge amount of capital. The assets and cash inflow of the company are used as securities for the debt portion. Thus, the PE fund buys out shares of a publicly listed company so that it becomes delisted and therefore private. The debt, having a lower cost of capital than equity, is employed by the investor as a leverage to increase the returns on the investment. Ordinarily, the debt to equity ratio is 70:30. The portfolio company is then subjected to “adhere to strict, results-oriented financial projections” and “operate the company within tight budgetary and operational constraints”. Therefore, this serves as an important revival mechanism for economically suffering companies by remodeling and restructuring them using debt.
NPAs have been defined as loans or advances for which the principal amount of the interest has been overdue for a period of more than 90 days. In their ledger, banks often classify it as a loss. Essentially, NPAs would include companies making losses. In my opinion, LBOs can step in to provide some hope of revival. The risk and corresponding returns are high in LBOs and would suit NPAs.
Legal Barriers to LBOs
In the Indian context, there have been LBOs since the Tata Tea’s LBO of the UK’s Tetley for 271 million euros in 2000. Many other multi-million and multi-billion LBOs funded by Indian companies followed suit. However, in all these transactions, the target has never been Indian. This is because the provisions stipulated in the Companies Act 2013, the RBI’s master circular, the FIPB’s press note, the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011, the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, and the SEBI guidelines work in tandem to block LBOs for Indian targets. It becomes imperative to closely examine at each of these legislations.
The RBI explicitly prohibits banks from providing loans and advances where the purpose of the loan is to purchase the shares of an Indian company. The Master Circular on Loan and Advances of July 2015 permits collateral for secured loans only for ‘working capital’ or ‘other productive purposes’. This, in effect, prevents PE funds from utilizing assets of a portfolio company as security for purchasing the portfolio company’s shares. The rationale behind this provision stems from the RBI’s conservative approach to ensure the safety of domestic banks. The domestic banks are not supposed to make advances on the basis of shares of the portfolio company and rather, the promoter or investor should fund the investments from their own pocket. The RBI also observed that banks work closely with private investors due to the multiplicity of transactions for the bank’s own growth. Thus, they recommended limiting the bank’s exposure to the capital market.
Now, it may be posited that banks are not the sole financial institutions and in fact, they only contributed to 50% of debt for LBOs in the EU in 2007. However, in the Indian capital market, the non-banking institutions are not developed enough and banks remain the primary source of capital. Non-banking financial institutions lack the structure to fund big-ticket LBOs.
In my opinion, this approach should be discarded. These transactions have been a part of successful PE environment in other jurisdictions and the same can be mirrored in India, if we lay down the correct infrastructure. This infrastructure would encapsulate corporate governance and sufficient checks and balances on the banks with their relations with private investors and private pool of capital.
Section 67(2) of the Companies Act 2013 forbids a public company or a private company that is a subsidiary of a public company from providing financial assistance for the purpose of subscribing or purchasing shares of other companies. Understandably, the purpose of this section was to combat trafficking company’s own shares in order to influence the price. Unfortunately, the legislators did not take into account the possibility of buyouts. Therefore, any asset provided by a company for such transaction will be therefore disallowed. In my view, the law should be amended to allow buyouts but at the same time provide an exception to prevent trafficking shares.
The FIPB served as the apex body and clearing authority for all foreign direct investment up to the amount of INR 1,200 crores. Through Press Note 9, it prevents Indian banks from lending money to foreign investors for the purpose of purchasing or subscribing shares of Indian companies. Therefore, these rules, along with the RBI guidelines, work in a pincer movement to make any possibility of LBOs by foreign PE fund bleak. Moreover, foreign PE funds need FIPB’s approval to open holding companies in India. Thus, a paradigm shift in government policy (both FDI policy and RBI policy) for Indian banks is needed to stimulate LBOs.
The foundation of private equity lies in the strategy of buying to sell. Exit process form the basis of every PE investment. In an LBO, the average time for exit is seven to ten years and the most common method is initial public offering. SEBI’s Issue of Capital and Disclosure Requirements Regulations 2018 lay down stringent guidelines which a newly revived company my find hard to comply with. For instance, pursuant to Regulation 6(1), prerequisites such as net tangible assets of INR 3 crore in the preceding three years and pre-tax operating profit around INR 15 crore in three out of last five years has to be fulfilled. Such a requirement is extremely onerous for an NPA.
Conclusion
The lack of conducive regulatory conditions for LBOs have resulted in minority investment based private equity model in India. However, at this juncture, we should recall the 2013 efforts of RBI where it mooted reforms to allow banks to finance entities that perform LBOs. This was also done in the backdrop of the issue of augmenting NPAs and it is time we take inspirations from the West’s traditional model of private equity.