Updated: Aug 29, 2020
By Cyril Amarchand
As the global tally of Covid-19 cases rises steadily, the pandemic has proven to be an unprecedented public health emergency of our time. With nations enforcing social distancing, lockdowns and travel restrictions, the global economy has witnessed a drastic downturn. India has been no exception to this. The business disruption caused by Covid-19 and the consequent impact on the economy is enormous. In addition to the fiscal stimulus, the Government has announced various policy measures to help businesses raise capital, defer expenses and essentially survive through this period but the efficacy of these measures is yet to be seen.
Given the above scenario, it is indeed an extra-ordinary time for private equity investors. Uncertain demand for businesses has affected their liquidity causing urgent capital needs and creating opportunities for investors. However, the opportunity comes with its own challenges given the uncertainty on future cash flows for these businesses. Some of the issues and trends that have come to the forefront are discussed below:
I. Valuation of Target Business
The uncertainty caused by the outbreak has raised a new challenge for the investors in terms of correctly valuing their target businesses. In view of the same, deals involving creative price structuring options such as deferred consideration (with payment of subsequent tranches made subject to performance of the target), earn-out provisions to give back the value to the seller, if realized, and locked-box mechanism if the time period between signing and closing is long, are expected. In cases where seller continues to be involved with the business, we might see more deals with convertible instruments or provision for multi-tranche investments to enable investors to price the deal based on future earning of the target rather than rely on estimates from the target entities. While each of these options will give the much-needed immediate liquidity to the target, it will also keep investor’s exposure to the minimum with scope of valuation adjustment in future. Another trend which is expected to pick up is convertible loan or transactions with part debt and part equity, specifically for investors who have flexibility to invest in both debt and equity. That said, it is worth noting that most of these options come with their own conditionalities (e.g. pricing norms) if the investor is a non-resident, and therefore, a careful consideration to their pros and cons in light of the desired commercial objective will be required. Further, to minimize any disputes the formula for such future conversion and the manner in which various inputs are calculated should be clearly spelt out in the documentation to ensure that there is no dispute at a later stage. Investors may also consider providing EBITDA or revenues over a couple of consecutive financial years as the basis for the conversion formula where appropriate to ensure that extra-ordinary income in a certain year does not skew the valuation.
II. PIPE Investments
One issue that has been an impediment for deals in the listed space is the regulatory requirement around the minimum price at which listed companies can issue equity securities to investors. Under the Securities and Exchange Board of India (Issue Of Capital And Disclosure Requirements) Regulations, 2018, listed companies in India can issue equity securities pursuant to a preferential allotment only at a price equal to or higher than the higher of the 2 weeks or 26 weeks average weekly high and low of the volume weighted average price of the related equity shares (the look back period is two weeks in case of investments by qualified institutional buyers). This requirement only applies to companies whose shares are frequently traded, the segment where most investments are likely to take place. Given the impact of the COVID-19 outbreak (and the resultant nation-wide lock down) on the Indian stock market is not more than 12-16 weeks old, the aforesaid look back period of 26 weeks for determining the floor price would have constituted partially of the pre-COVID-19 period, resulting in the regulatory floor price being higher than the current market price, particularly, in the context of companies whose stock prices have fallen significantly due the impact Covid-19 outbreak. This had resulted in a stall in PIPE investments.
Recognizing this issue, an alternative pricing methodology with the look back period of 12 weeks has now been allowed. Additionally, the look-back period has been reduced to 2 weeks for companies which qualify as stressed companies as per the conditions prescribed by the regulator. However, these options come at a cost of an extended lock-in of 3 years, as opposed to a lock in of 1 year in case of issuance under the 26 week pricing methodology.
While these relaxations do provide some relief to listed companies, it remains yet to be seen if investors are willing to accept the 3-year lock-in.
In addition to the above, regulator has also taken the following steps to encourage fund raising by listed companies:
The threshold for creeping acquisition by promoters has been increased to 10% from existing 5%, therefore, promoters can now increase their shareholding in the current financial year up to 10% without having to make a public offer. This relaxation only applies to preferential allotment and not to secondary acquisitions.
The minimum subscription for a rights issue to be successful has been decreased to 75% from the existing 90% subject to 75% of the issue size being utilized for the objects other than general corporate purpose. Conditions for undertaking rights issue in fast track mode have been relaxed.
The timeline for validity period of regulator’s observations on public offer and rights issue offer documents has been extended by 6 months to allow companies more time to decide on the fund raise.
While the above steps do seem to be in the right direction, it may be too soon to comment if these are enough to provide the required stimuli to fund raising by listed companies.
III. Due Diligence
With many Indian companies postponing announcement of their financial results on account of disruptions caused by Covid-19 coupled with the fact that the Covid-19 impacted period falls largely post the end of the financial year, makes it extremely critical for investors to conduct a proper financial and legal diligence on the target. Investors may require the target to get the balance sheet of the impacted period audited in order to get comfortable with the recorded revenues. Additionally, a more focussed review of target’s business continuity plan, readiness to deal with a potential second wave of the pandemic and liquidity status is expected. In terms of legal due diligence, review of contractual obligations of the target, the protection provided thereunder to deal with pandemic like situation and potential for a dispute is going to be critical.
The due diligence process in itself is likely to undergo a change with less reliance on physical meetings and site visits, and more on virtual data rooms. This may be the preferred approach for legal diligence even in the pre-Covid situation but may pose challenges for operational diligences.
IV. Does COVID-19 constitute MAE?
One of the other key issues that have come to the forefront in light of the outbreak is whether Covide-19 constitutes ‘material adverse effect’ or ‘material adverse change’ (hereinafter, referred to as “MAE”). MAE clauses serve many functions, and most importantly, occurrence of MAE provides the investor an option to walk out of the deal. Bestowing the investor with such an option, incentivises the target company and its management to ensure that value, on the basis of which the investor had agreed to invest, is protected, and allocates business risks and risks arising from unforeseen events between the target company and investors.
It is important to note that MAE and its consequences do not find any source in statutes and are purely contractual rights. In the context of private equity transactions, a typical MAE definition includes any circumstance, change or effect that has, or is reasonably likely to have a material adverse effect on the business, business prospects, financial condition or assets of the target company. In some cases, target companies /sellers negotiate carve outs for general market and industry related risks, except where they have been disproportionately impacted by the same. With few exceptions, the definition of MAE is intentionally kept subjective, broad and to a certain extent vague, presumably because it is impossible for the parties to upfront pen down all possible unforeseen events, which may impact the commercials of the deal, quantify the impact of such events and agree on risk allocation between themselves.
With respect to judicial treatment of MAE, Indian jurisprudence provides limited guidance on MAE, and no standard test has been developed to determine if an act constitutes MAE.
However, some of the key elements that may be considered for the purpose of assessing whether COVID-19 would constitute are as follows:
(i) the quantum of economic impact of COVID-19 outbreak on the business of the target company – the economic impact on the target company as a result of COVID-19 outbreak would be considered as the trigger for MAE, rather than the pandemic as a whole.
(ii) the durational significance of the economic impact of COVID-19 outbreak on the target company – the duration of the economic impact on the target company should be long enough to make an impact, as a whole, materially adverse to the target company.
(iii) the foreseeability of the impact – whether the parties were in a position to foresee the occurrence of the alleged MAE at the time of signing of the definitive documents may play a critical role in determining whether the MAE clause under an agreement can be invoked.
Given the outbreak is no longer an unknown risk, in respect of the deals which are executed post the outbreak, it may be reasonably expected that the investor has taken into account Covid-19’s impact on the target in its investment appraisal, therefore, the outbreak in itself cannot be claimed as a ‘material adverse change’ between signing and closing. However, that should not stop the investor from invoking MAE if the impact of Covid-19 has significantly deteriorated since the execution of the transaction documents, including on account of a second wave of the pandemic in the area where the target operates. It is therefore advisable that such a situation is expressly built-in in the transaction documents.
That said, a strong push back from the sellers/ investee companies is also expected in the interest of deal certainty.
V. Board Responsibility in Covid-19 Crisis
The board of directors have a fiduciary duty to act in the best interest of the company and its stakeholders. The duty is higher, and under stricter scrutiny, in face of a crisis, as the board is expected to help navigate the company out of the crisis. The duty on an investor’s nominee director will not be any different, therefore, it may no longer be possible for a nominee director to be a mere spectator to company’s actions. A more active role in the operations of the target will be expected as matters which were otherwise in ordinary course and delegated to the management may become key strategic decisions requiring scrutiny by the board. Given the dual role played by a nominee director, it will pose additional challenges requiring careful consideration.
While it is undisputed that COVID-19 has created challenges for private equity investors both in respect of negotiating a new deal and management of existing portfolio, it has, at the same time, given rise to new opportunities to invest in companies which are, or will be, in need of funds due to a steep fall in their revenues (without proportionate fall in expenses) as a result of the outbreak. With the right investment strategy, backed by a sound transaction structure, investors may mitigate the risks involved and at the same time reap benefits of the upside of the economy’s return to normalcy.
About the authors:
Ravindra Bandhakavi is Partner (Head - Private Equity) in the general corporate practice of the firm. His expertise includes Private Equity and Mergers and Acquisition transactions. He is known to advise several Private Equity Funds and Financial Institutions on their investments in India across diverse industries.
With over 18-year experience, Ravindra has been recognised as a Leading Practitioner in India by Euromoney’s Asia Law. Chambers and Partners has consistently ranked him as a Leading Lawyer in Private Equity in India. He has also been regarded as a Leading Practitioner for Investment Funds by Legal 500.
He can be reached at email@example.com.
Poornima Singh is an associate in the General Corporate practice group at the Delhi office of Cyril Amarchand Mangaldas. She advises on private equity and M&A transactions.