Invest for the long haul. Don’t get too greedy and don’t get too scared.”- Shelby MC Davis, Wall Street legend
Private equity play in India has seen a sea change in recent times. Historically, PE players used to come on boards of companies as pure-play financial investors after picking up minority stakes with the standard investor protection rights attached. However, over the past few years, the PE pivot has been shifting to control deals triggered by the interplay of a bevy of factors such as elevated level of PE dry powder (cash pile), maturity of the companies and the nouveau trend of promoters looking for exit options by selling majority stake along with the ceding of management control to PE firms.
Through control deals, PE players get enough powers to monitor and manage their portfolio companies’ decision-making process, implement strategies and introduce sound corporate governance practices to spur growth and business expansion.
Recent research has highlighted this trend and data shows that the trending themes in the PE landscape last year were revival of startups, continued uptick in control deals and larger bets.
While this trend of swelling tide of control deals is expected to spill over to the next few years, promoters who are ready to give up the management control of their companies in favour of PE players have to be mindful of certain factors before they take a call on control deals. In what follows, we discuss certain broad issues that promoters need to be cautious about while negotiating a control transaction in order to safeguard their interests and avoid any pitfalls in the future.
Management and governance of the company: PE investors, as majority stakeholders, would typically want to take control of the day-to-day running of the business, which may lead to promoters losing their say in the functioning of the company even on certain basic elements of business such as formulating strategies, business plans, approving budgets, taking hiring and firing decisions vis-à-vis key employees and/or the ability of choosing the management team.
In such a scenario, a balance needs to be struck between the widespread powers of PE investors in their role as majority shareholders and operational freedom which needs to be provided to the original promoters (now turned minority shareholders). It is imperative for promoters to seek affirmative voting rights on certain fundamental and critical matters at the board and shareholders’ levels, which also equally affects the promoters’ continuing interest in the company.
In cases where minority promoters continue to play a key role after the control transaction, certain incentive structures can be formulated to incentivise and provide an upside for promoters, which may be determined on the basis of performance/financial parameters/milestones by the promoters and the company over an agreed period of time.
Another aspect in relation to the management and governance of the company in a control deal is classification of certain key persons/directors of the company as “managers” or “officer in default” or “occupiers” of any premises used by the firm, or an “employer” of the employees of the company. It may be critical for the promoters to require the PE investors to designate their directors and person(s) within an agreed time frame as “persons/ officers in charge/ “occupier”, etc. for the purposes of compliance with applicable laws and ensure that the promoters and/or their directors are not included within the said scope.
Suitable protection measures in the form of indemnification by way of obtaining Directors’ and Officers’ insurance policy also ought to be incorporated in case of any action, liabilities or proceedings arising on account of any promoter and/or promoter director being construed or deemed as an “occupier” or “officer in default/charge”.
Future sale of ownership interest by PE investors: In the event of stake sale by PE investors through a secondary sale to a third party (whether to a financial or strategic investor/third-party purchaser), such third-party purchaser is most likely to seek business-related representations, warranties and indemnities from the PE investors. Such representations, warranties and indemnities to the third-party purchaser should be provided by the PE investors since the business and operations of the company are being controlled by the PE investor and the promoters holding minority stake should not be obligated to undertake such disproportionate obligations.
Exit rights: Promoters should also negotiate various exit rights with the controlling PE investors including the right to participate in the exit along with the PE investor. With promoters being in a minority, it may be difficult for them to independently exit the company and derive economic value for their shareholding in the future.
Others: There are additional aspects that merit promoters’ attention. One, the securities held by the promoters shall be freely transferable without any lock-in requirements or a larger proportion of the promoters’ shareholding shall be freely transferable for the purposes of creating liquidity for exigency/emergency purposes and/or tax and/or estate planning purposes.
Two, there should be a restriction on the transfer of securities by PE investors to a competitor until the time promoters are shareholders of the company (or until an agreed promoter shareholding threshold) as there might be various competing entities with which promoters may not be comfortable or may have alignment issues. Three, other transactional aspects, inter-alia powers and duties of the promoters, non-compete and non-solicit restrictions and termination provisions (with cause/without cause) in the employment agreements of the promoters should be well negotiated by the promoters.
Many global funds now prefer to go for control deals given their greater bandwidth and domain/sectoral expertise. The experience of a wider and larger portfolio, which is further aided by increasing the number of successful exit deals, along with the ability of PE investors to dictate the terms of exits, which typically assures them better returns independent of promoter intervention, is aiding the trend.
Control transactions can be a win-win situation for both the PE investors and the promoters, with PE investors striving to generate higher returns and successful exit. And, benefits can accrue to the company from the expertise, global reach, professional management and vision of the PE investors. But care should be taken by the promoters to ensure that the control transaction results in effective synergy between the parties along with protection for promoters’ interests so that they are able to derive optimal value from the company they have set up and nurtured.
Archana Khosla is founding partner and Vivek Jha is associate partner at law firm Vertices Partners. Views are their own.