Foreign Investment In India: Key Consideration

As we look ahead to 2024, it is expected that the investment environment will witness an upwards trajectory fuelled by stabilization of interest rates, increased funding capability of private equity (PE) and venture capital investors and the focus of the Indian government on indigenous manufacturing which is likely to result in inbound M&A.

Introduction

In 2023, the Indian business landscape experienced a transformation marked by an unprecedented surge in mergers and acquisitions (M&A) activities. Despite global challenges, including widespread interest rate hikes, banking instability in the US and Europe, and geopolitical conflicts like Russia-Ukraine and Israel-Hamas, India maintained a robust economic trajectory, projecting an annual growth of 6-7%. The M&A landscape in India showed resilience, with 2023 activity remaining strong, surpassing the average of the past decade (excluding 2022). An increase in the share of deals in sectors like renewable energy, infrastructure, manufacturing, and logistics was seen which can be attributed to a structural growth outlook in these sectors and positive policies such as production linked incentive schemes brought in by the government.

As we look ahead to 2024, it is expected that the investment environment will witness an upwards trajectory fuelled by stabilization of interest rates, increased funding capability of private equity (PE) and venture capital investors and the focus of the Indian government on indigenous manufacturing which is likely to result in inbound M&A.

Considerations

In light of the anticipated rise in M&A and PE activity in India, this article outlines specific structuring considerations which investors can deliberate on when investing in India. Since foreign exchange in India is a regulated activity, certain conditionalities are applicable when making foreign investment in India. These include sectoral caps on investment, pricing guidelines and restrictions on purchase price holdbacks. Over time, various structures have developed which provide parties with sufficient operational flexibility while functioning within the regulatory framework. We have discussed some of these below:

Optionality Clauses: Optionality clauses are permitted for equity instruments in India subject to a minimum lock-in of one year (or as prescribed for a specific sector). However, such a clause cannot allow assured returns to the non-resident investor. It may be noted, however, that this does not limit the investor’s ability to claim damages for a breach of contract. In the case of Cruz City I Mauritius Holdings v. Unitech Limited, a put option provided to Cruz City could be exercised only within a specified time period and was contingent on the delay of the commencement of the project. The court allowed the exercising of the put option clause, noting that the clause was not an open-ended assured return clause, but rather was in the nature of a claim for damages based on a breach of obligations. Similarly, in the case of Banyan Tree Growth Capital v. Axiom, it was held that a put option clause which did not provide for open-ended assured returns, was time-bound, contingent on the occurrence of an event and in compliance with the pricing guidelines would not be in violation of the Foreign Exchange Management Act, 1999. Accordingly, investors should ensure that they carefully structure optionality clauses in equity instruments to align with the regulatory framework while ensuring that no assured returns are provided through such clauses.

Anti-trust considerations: The Indian Competition Act, 2002 (Competition Act), mandates prior approval of the Competition Commission of India (CCI) for acquisitions, mergers, or amalgamations exceeding the prescribed asset and turnover threshold of the parties (and group). The Ministry of Corporate Affairs (MCA), through a recent notificationincreased this asset and turnover threshold for approval for the ‘direct parties test’ and the ‘group test’. The threshold has increased by 150% over the original amount provided in the Competition Act and 25% over the previously applicable threshold.However, de minimis exemption notified by the MCA is available for transactions below the specified asset or turnover threshold. Under the recently revised notification, the exemption is available if the value of assets being acquired is less than INR 450 crore or turnover of acquired entity is not more than INR 1,250 crore. This exemption is applicable until March 2026.

Further, the Competition (Amendment) Act, 2023, introduced the deal value threshold test which requires CCI approval for any transaction with a deal value exceeding INR 2,000 crore and if such enterprise (being acquired, merged, etc.) has ‘substantial business operations in India.’ This provision has not been enacted yet but is expected to be enforced soon. Additionally, there is a lack of clarity on the calculation of ‘value of the transaction’ and the meaning of ‘substantial business operation in India.’ While the draft CCI (Combination) Regulations, 2023 provided some clarity in this respect, the regulations are still in their draft form and several questions remained unanswered. Therefore, foreign investors will need to undertake an analysis from this perspective to assess if the proposed transaction requires notification to the CCI beforehand. In certain circumstances where notifiability of the transaction is unclear, the investor through its counsel can also have pre-filing consultations with the CCI in this respect.

Representations and warranties insurance: A method aimed at protecting the interest of the buyer, which is gaining popularity, is the use of representations and warranties (R&W) insurance.

Under this, either party to the transaction can purchase an insurance policy to protect themselves against future breach of warranties or indemnity claims. While seller side coverage is usually a liability

policy, covering the seller’s liability for claims of breach of a representation of warranty, buyer side coverage is a form of first-party coverage, directly compensating the buyer for any breaches by the seller. Exclusions in such policies can include deal-specific exclusions depending on the target and nature of the sector in which the target operates, forward-looking warranties, and world events such as COVID -19.

Benefits of procuring an R&W insurance policy include: (i) avoiding post-closing conflicts between the parties; (ii) mitigating concerns around seller insolvency; (iii) permitting the seller to use proceeds from a sale more quickly; and (iv) in the case where PE funds are providing representations and warranties, the survival period of the warranties may be longer than the fund life i.e., that while warranties like those for tax could last for 7 years after closing, the fund could be liquidated prior to the expiry of this survival period.

Downstream acquisition financing: Foreign-owned and controlled companies (FOCCs) are not permitted to undertake any leverage in the Indian market for the acquisition of shares. Further, FOCCs are only permitted to make investments in India through investment received from abroad which is subject to entry routes, sectoral caps, pricing guidelines and other attendant conditions, or internal accruals. Consequently, an FOCC cannot avail any finance from Indian banks, financial institutions or domestic funds for the purposes of acquiring an Indian target entity. In addition, commercial borrowings from abroad are not permitted to be invested in equity instruments as well. However, FOCCs may access debt financing through the issuance of non-convertible debentures which may be subscribed to by foreign portfolio investors. Accordingly, FOCCs planning on making further investments in India must make sure to have sufficient available funds received from the foreign parent or through internal accruals.

Conclusion

India’s vibrant and growing economy, coupled with the government actively promoting foreign investment, presents a compelling case for international investors in 2024. With a projected annual growth of 6.7% for FY-2024, a stabilizing investment environment, and increasing M&A and PE activity poised to be propelled further by the upcoming 2024 general elections, the landscape is fertile for fruitful partnerships. While specific considerations exist regarding exchange control, anti-trust, and financing, these can be effectively navigated. Sectors like manufacturing, green energy, semiconductors, healthcare, electric vehicles are likely to see increased investments in the coming year due to positive government initiatives and policy incentives.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.