What PEs want from investee firms

Gaps in business plans, corp governance, affirmative rights and exit routes are key contentious areas between PE investors and their investee firms

Private equity (PE) investments are on the rise. According to data issued last week by the Securities and Exchange Board of India (Sebi), total commitments raised by three categories of Alternative Investment Funds (AIFs) had crossed Rs 30,000 crore at the end of 2015, a 55 per cent increase over the previous year.

Despite all the hype around investment in start-ups, the growth this year in that segment was considerably lower than the 77 per cent recorded in calendar 2014. And, while investments made by AIFs shot up 145 per cent to Rs 14,031 crore from the Rs 5,721 crore at the end of the previous year, this was slower than the 211 per cent growth in calendar 2014.

It is natural that as the base widens, growth will moderate and it is encouraging to see the segment growing at a significant pace every year. However, it is a reality that this represents only a fraction of funds active here. Even four years after the AIF framework was put in place by Sebi, a large section of the segment has chosen to remain outside. This in itself is a major ethical issue, apart from being a concern for the regulator, which the segment has to address.

Yet, it is undeniable that the PE segment has become a significant stakeholder in corporate India. With investment of $60 billion between 2003 and 2011 ripe for exit, there is scope for a lot of action, good and bad, in these companies. What do PEs think about ethics and corporate governance in their investee companies?

In a recent report, titled ‘A field guide to shareholder redressal in India’, Institutional Investor Advisory Services (IiAS) studies governance issues faced by PEs. Differences on the business plans, corporate governance issues, especially in related party transactions (RPT), adherence to affirmative rights and meeting exit-related conditions are key areas of differences between PE investors and their investee companies, it said.

Reported fraud by investee companies also saw a significant rise, as the challenging business environment led to some promoters taking shortcuts. IiAS found investors had typically resolved governance and exit issues bilaterally.

According to the proxy firm, PEs have taken several steps to address potential problems and these could help better the governance in investee companies. These are:

• Tighter SHA terms: PEs are now focusing on tighter shareholder agreement terms, from the period of 2005-2011 when competitive conditions had investors agreeing to lax terms that did not stand the test of tough economic conditions.
• Deep dive into RPTs: Financial audit is now being undertaken in far greater depth, with particular focus on aspects such as confirming the cash on books, tracing key transactions through accounts and undertaking a deep dive into related party transactions.
• Background checks: Forensic audits to check the background of a promoter, any cash leakages, criminal cases, etc, are being made part of the standard due-diligence process prior to investment.
• Incentives for good behaviour: Incorporating upfront terms in the SHA that incentivise the promoter to act in a positive manner or oblige the latter to act to prevent penal provisions.
• Spirit of law: Eschewing certain structures that tested the spirit of Indian law as investee companies successfully argued against adhering to such terms.
• Independent nominees: Some PE investors are reviewing whether it is better to appoint independents to represent the PE fund on the board of an investee company (instead of a member of the PE fund), especially in the context of recent law, as it reduces conflict situations that have been used against them by these companies.