The Practical Lawyer

Exit Options for Private Equity Investors

Introduction Private equity investors, at the time of entry, must be very clear about their exit options. In fact, knowledge
of exit options is a necessary concomitant of entry. Profits accruing to private equity investors hinges on their terms of
exit and therefore the investors want to be prepared right at the outset. Preparation typically includes the following
— outlining the key features of exit strategy in the investment documentation, strengthening the company’s
Board, developing a detailed growth strategy and creating an exit committee to analyse and spearhead the terms of exit.
For a long time, the primary mode of exit has been an initial public offer (IPO). However, post the recent recession,
private equity investors are looking at alternate options. These options include buy-back or redemption of shares, put
option on the promoters, sale of shares to a financial buyer or another private equity investor, strategic sale or merger
with a listed company. This article discusses all these options — some frequently used and others not so
frequently.

Modes of exits IPO This is the traditionally preferred route. An IPO is not an exit in itself. Private equity investors will
have a right to offer their shares for sale under an IPO and then exit. To ensure that the investor can effectively achieve
this, investment documents typically specify the following: first, the management must exercise voting rights to pass IPO-
related resolutions; second, the investor must have an enforceable right to offer and enforce the “offer for
sale”; and third, the investor must not be a promoter, in order to make certain that provisions on promoter lock-in
post IPO do not apply. Several private equity investors invest as SEBI registered foreign venture capital investors (FVCI)
or venture capital funds (VCFs) for various reasons: one, the lock-in requirement post IPO for non-promoter investors
does not apply to FVCIs/VCFs so long as they were holding equity shares for at least 1 year pre-IPO, second, the pricing
regulations do not apply both at entry and exit and third, that FVCIs and VCFs qualify as “qualified institutional
buyers” (QIBs). QIB benefits include the fact that the price of shares issued to QIBs on preferential basis are
calculated on the average of the weekly high and low of the closing prices of the related shares quoted on a stock
exchange during the 2 weeks preceding the relevant date as against a 6 month period that apply to others; hence the
odds against the pricing of QIB shares being adversely affected by any radical change in prices over a period of time are
lesser.

The benefits of an IPO are apparent: higher valuation can be achieved so long as the markets are buoyant,
management will cooperate since they can remain in operational control and the investor can choose to benefit from a
longer term shareholding in the company. The main downside is that valuation is dependent on prevailing market
conditions. Further, an IPO involves considerable transaction costs; the transaction requires careful planning and the
process takes long to implement, during which period, a drastic change in market changes may warrant abandonment of
the project. The other drawback is that the IPO may not give large private equity investors a full clean exit. The public
generally perceives this as lack of investor confidence in the company which in turn may have downside effects on the
market valuation of the company. Anecdotal experience shows in spite of the recovery of the economy in 2010, there
were certain IPO exits: Credit Suisse PE Asia from Shree Ganesh Jewellery House, Trikona Trinity from IL&FS
Transportation Networks, ChrysCapital from Hathway Cable, JP Morgan Partners from Jubilant Foodworks and Temasek
from Infinite Computer Solutions India.

Buy-back of shares Private equity investors could agree to exit via a buy-back of shares at a mutually agreed internal
rate of return. A buy-back should conform to the guidelines laid down in the Companies Act, 1956 read with the Private
Limited Company and Unlisted Public Limited Company (Buy-Back of Securities) Rules, 1999, in case of private
companies and unlisted public companies and the SEBI (Buy-Back of Securities) Regulations, 1999, in case of public
listed companies.

The guidelines under the said provisions inter alia provide that in a year there can only be a buy-back of 25% shares of
the company (prescribed threshold), buy-back is permitted only from free reserves or from the securities premium
account, a buy-back of a certain kind of shares cannot be made out of the proceeds of an earlier issue of the same kind
of shares and the buy-back debt-equity ratio post buy-back cannot exceed 2:1. Further since an offer for buy-back needs
to be made pro rata to all shareholders, it is usual to enter into an agreement with some of the promoters/shareholders
where they agree not to subscribe to the shares else there would be a risk of the buy-back exceeding the prescribed
threshold and not allowing a complete exit to the PE investor. Private equity investors must ensure that the
company’s articles of association permit a buy-back of shares. Although this mode of exit is not as conventional
as an IPO exit, several companies are taking recourse to a buy-back. Managements cite the rationale as maintaining
control over the enterprise and uncertainty in the IPO market. Certain private equity investors use this as a last resort
when they know that an enterprise has not had a significant increase in its value and there is no prospect of an
alternative exit at an attractive valuation but the company has generated sufficient profit to fund the buy-back. Examples
of buy-back exits during the year 2010 are: buy-back of Global Environment Fund and Draper Fisher Jurvetson’s
shareholding in Reva Electric Car Co., redemption of Blackstone’s investment in Emcure Pharma and Emaar-
MFG’s buy-back from Citi Venture Capital International. Enforcing a buy-back and a put option (discussed below),
is a challenge considering the Indian regulatory regime. In a nutshell, following a decision of the Bombay High Court in
Niskalp Investments and Trading Co. Ltd. v. Hinduja TMT Ltd. 1, a buy-back or put option of shares of a public company,
whether listed or unlisted, can be construed to be a transaction in securities, not being on a “spot delivery”
basis (as required under the Securities Contract Regulation Act, 1956 or SCRA) and hence void and unenforceable.
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However, this summation is largely debated on the interpretation that a put option agreement/buy-back agreement does
not create an obligation when executed; it is a contingent contract and hence the need to conform to the SCRA spot
delivery requirement occurs only when the option is exercised or the obligation, created.

Put option on promoters An exit via this route involves a put option right with the private equity investors on shares of
the promoters of the company. Considering the enforceability issues discussed under the buy-back option above
applicable to public companies, investors use a private company structure to hold the promoter shares or create a
promoterÓowned company overseas that would hold shares in the investee company (Overseas Company Holding) and
place the Overseas Company Holding in escrow. The parties must also ensure that a transfer of shares consequent to
exercise of put option is in conformity with the pricing guidelines of RBI.

Right of first offer (ROFO), right of first refusal (ROFR), tag along, drag along These are standard transfer
restrictions/exit mechanisms agreed under investment documentation. Private equity investors prefer a ROFO over a
ROFR since it helps them retain control over the process of price discovery. Further, investors may find it difficult to exit
via a ROFR since potential acquirers may worry that even after completion of price fixing following extensive diligence,
promoters may ultimately acquire the shares. A tag along right, being a right to “piggyback” with the selling
shareholder, is suitable for minority shareholders. A drag along right, being a right to compel the other shareholders to
sell along with it is suitable for majority shareholders. Enforceability of these transfer restrictions has always been a
challenge given the provisions contained in Section 111-A of the Companies Act. A recent development that has made
private equity investors rejoice, is the Bombay High Court’s decision in Holdings Ltd. v. Shyam Madanmohan
Ruia2. Unlike decisions of various courts in the past, the High Court in this decision has upheld the enforceability of all
private arrangements including a ROFR and ROFO and the principle of the sanctity of consensually executed
shareholder agreements.

Sale to strategic buyers or financial buyers The differences between strategic buyers and financial buyers are many but
the most significant one is their approach to acquisitions. While strategic buyers want to “buy and hold”,
financial buyers want to “buy low and exit high”.

A sale is preferred for the reason that that private equity investor will have to deal only with one buyer unlike in an IPO,
where multi parties are involved. Further, a sale provides payment in cash and a clean and complete exit for the private
equity investor. However, the company’s management may resist due to fear of takeover by a competitor and
dilution of their independence.

A private equity investor may also sell to another private equity buyer (PE buyer) usually referred to as a
“secondary buyout”). This type of exit appears to have developed for various reasons: one, that with
private equity investors increasingly engaging in niche areas, non-specialist investors have begun to sell to more
specialist firms. Further, certain private equity investors may wish to reduce their deal life in the company so they can
look at more inviting projects. It is also possible that private equity investors may exit when both the management and the
investors believe that a larger private equity investor will add value to a transaction. For instance in 2005, Crossover
Advisors, a private equity firm invested in an automobile component manufacturer, Indo Schottle Auto Components.
Once their market demand increased after procuring orders from Volkswagen and General Motors, a decision was taken
to co-opt a large partner such as ICICI Ventures. Crossover Advisors exited through a sale to ICICI in 2007. One difficulty
that private equity sellers face in such a secondary buyout is that the PE buyer wants strong warranty protection while
the private equity seller may prefer to provide minimum warranty protection. A private equity seller’s approach on
exit is based on return of funds to various categories of investors constituting the fund’s management structure;
and therefore cannot extend post deal contingent warranties. A second argument is that since private equity investors do
not form part of the management and do not supervise the routine operations of the company; they have no means to
assess the risks attached to such warranties.

Merger An exit route that is used, but only as a “back-up”, is a merger of an illiquid/unlisted company with
a listed company. However, this is rarely followed in view of tedious litigation processes associated with mergers, in India.

Other exit options Set out below are other modes of exit, not typical in India but discussed for academic interest.

Break-ups: This exit route may be used by private equity investors who invested in a series of diverse non-core
businesses with the intention of selling them piecemeal to various buyers who will value the business. The sale would
thus involve “break-up” of the business at a price that is invariably higher than the initial acquisition price.

Portfolio sale: This is typically used when private equity investors wish to exit from all their investee companies
simultaneously. The primary reason for use of this route would be an ageing private equity fund that demands an early
exit.

Conclusion One can surmise that weighing the pros and cons of the various exit routes, while bearing in mind the
nature and motives of the private equity investor is critical to achieve the expected return on exit. Structuring and
recording the exit terms achieves a focus-driven operation of the investee company and if all goes well, one will see
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private equity investors — enter, transform and exit happy.

- (2008) 143 Comp Cas 204 (Bom)

- Appeal No. 855 of 2003 decided on 1-9-2010 (Bom)

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