“Control” and Conquer: Key Legal Considerations

Private equity has long been a financial hive for investors seeking higher yields. Despite signs of stagnancy in deal-making activities in India, ‘control’ transactions continue to emerge as the key to unlocking greater value for investors. These transactions represent a larger financial game plan where investors guide the journey of their portfolio companies.

In the context of private equity, a ‘control’ transaction refers to an investment by a PE investor whereby it holds a significant ownership stake in the investee company, allowing the investor to exercise ‘control’ over the company’s management, operations, and strategic decisions.

 Some of the factors that suits control transactions are:

• Succession issues: In India, 85% of incorporated businesses are family owned. Founders without succession plans often favour control transactions with private equities due to the pool of funds that can be accessed by them. For instance, promoters of Cipla were considering its sale due to succession issues;

• Unwanted or non-core assets: Large Indian conglomerates are typically immersed in diverse industries. To increase focus on profitability, these conglomerates may choose to focus on their ‘core’ sectors. Resultantly, investment opportunities have cropped up for investors where conglomerates have sought to sell and monetize their non-core assets; and

• Collective sale by investors’ consortium: In its growth cycle, companies raise several rounds of capital through various investors, resulting in a diversified capital table. To gain maximum value, a sale must be made to the best-suited buyer. Buyers typically give better value to acquire ‘control’ of a company, commonly referred to as ‘control premium’. Consequently, minority financial investors consider exiting collectively by delivering ‘control’ to the buyer.

So, what makes control transactions attractive? Some of the benefits are as follows:

• Synergies: Private equity funds are well-connected and have interests in companies across jurisdictions. PE investors have the ability to introduce better commercial opportunities for investee companies, thereby expanding the reach of such companies, achieving economies of scale, and ultimately improving value. For example, KKR acquired a controlling interest in Alliance Tyres and exited with a two-fold return on the sale to Yokohoma Tyres. A key factor attributed to this success was KKR helping Alliance with “deeper penetration in key markets such as the US and Europe” which helped “drive the valuation and make such a successful exit for KKR”;

• Exit strategies: Investors holding a minority stake in companies usually rely on promoters to explore and implement exit scenarios (such as an IPO). Being the majority shareholder of companies, private equities have the ability to drive the exit strategy and reduce reliance on promoters to achieve the desired exit;

• Exit pricing: The controlling investor has the flexibility to implement investment strategies without having to share exit upside with several shareholders.

Control transactions come with their own set of legal hurdles both for promoters and investors. Some of these are discussed below:

• Transition period: Typically, control transactions are of 2 types, one where the existing promoter retains operational control and the other where the existing promoter has exited the investee company. In the latter, the investee company is professionally managed by a management team appointed by the investor. Investors should ensure that a transition period is clearly defined in the definitive documents, during which the exiting promoter would assist in the handover of the day-to-day functioning to the management team. To incentivise the exiting promoter, a portion of the consideration can be allocated towards the satisfactory completion of the transition support;

• Due diligence: Most aspects of legal due diligence that apply to minority private equity transactions also apply to control transactions. However, investors should delve deeper into their assessment of obligations and liabilities that come with exercising control. For instance, in infrastructure deals, several concession / banking arrangements require guarantees (including performance guarantees) from majority shareholders of the concessionaire;

• Degrees of control: While deciding the deal terms, investors should consider the rights that will flow from a decision-making perspective. A higher shareholding percentage would result in greater decisional power in the hands of controlling investors - holding more than 90% of the shareholding of a company gives one absolute control; whilst holding 75% of the shareholding gives one control over almost all shareholder matters.

• Reserved matters for founders: In control transactions where the founder continues in the company, the founder may negotiate consent rights on certain matters, all of which depend on their promised economics and/or role in the company, post-deal. Investors should be wary that these consent rights could impact the strategy of the company and defeat the purpose of the ‘control’ acquisition.  A balance is generally achieved when these are limited to prevent leakage of value or rights detrimental only to the founder;

• Warranties and indemnities: A key debate lies in how the controlling private equity investor will take on the liability for business warranties on a future sale. Continuing founders may not be amenable to contractually bind themselves to such obligations on a go-forward basis. Potential buyers would need some protection in a future sale. Although it is good to debate these matters upfront, relying on a W&I insurance policy has become standard and a fair solution for parties;

• Disallowance of “accumulated losses”: Control buyers must take into consideration the financial impact of Section 79 of the Income Tax Act, 1961, which inter-alia disallows (subject to prescribed exemptions) any accumulated losses of any year prior to the previous year (that is, the relevant year being assessed for tax) from being carried forward, in a change in control of a closely held company. Simply put, in case of such transactions, in the absence of any exemptions being applicable, the accumulated losses cannot be carried forward;

• Open offer and delisting issues in listed space: The SEBI Takeover Code inter alia stipulates that in an acquisition of ‘control’ of a listed target company, the acquirer must make an open offer to acquire additional shares from the public shareholders as a condition to consummation of the control acquisition. Investors may also prefer to delist these investee companies from the exchanges. The SEBI Delisting Regulations permit third-party acquirers to buy out the existing promoters of a listed company and simultaneously propose a delisting of the target company. However, this regulation comes with its own lacunae, for instance, it does not expressly permit existing promoters to be part of the promoter group after the offer (requiring them to hold less than 10% of the company post the delisting). Practically, this route has not seen much success. Recently, Blackstone failed in its attempt to delist R Systems after acquiring its control as the delisting offer did not muster the requisite tenders;

• Dependency on promoters: In the Indian context, it is fairly common for investee companies to have dependencies on the relationships of the founders or promoter entities. Care must be taken to ensure these relations transition and enforceable non-compete obligations are entered with founders to protect the assets bought.

To summarize, embarking on a control transaction is not merely a commercial decision; it's a legal one as well. Not every company and private equity firm are suited for this path. These transactions require a thorough understanding of the target company, its industry, and the motivations behind the transaction. The suitability of a control transaction also hinges on various factors, including the reason why the previous shareholder ceded control.

About the author: Simone Reis is a Partner and Shwetank Chaubey is a Senior Associate at Anagram Partners.

Disclaimer: The contents of this article do not necessarily reflect the views/position of Anagram Partners but remain solely those of the author(s). This article is intended only as a general discussion of issues and is not intended for any solicitation of work. It should not be regarded as legal advice and no legal or business decision should be based on its content.