Working of Private Equity Firms

Presented by:Sovit – 126

Prathamesh Karvande – 95Apurva Sood – 125Aashray Vasa – 129

Palak Saraf - 118Nayant Manek – 99

Private Equity - An introduction• Source of Investment Capital• High Net worth Individuals• Investing and Acquiring Equity Stakes• Funds gathering from investors• Minority position in Firm• Target-not a Public Traded Company• Usually Public Entity Delists

4 Step- Process Cycle• There are four basic things private equity investors do to earn money.• Raise money from Limited Partners (LPs) like pension and retirement

funds, endowments, insurance companies, and wealthy individuals• Source, diligence, and close deals to acquire companies• Improve operations, cut costs, and tighten management in their

portfolio companies• Sell portfolio companies (i.e., exit them) at a profit

Process of Acquiring a Firm• Through LBO’s• Buy all the shares if Public Listed• Money is used to buy out firm’s owners• Using the Funds to grow a firm• Paying off Debt of target firm• Private equity holder's control

Process of Raising Money

• Getting Capital Commitments from external Financial Institutions (LP)• 1-5 % of their own capital• Road shows or Placement agent• First close vs. Final close.• First close when a certain threshold of money has been raised, the PE

firm can begin making investments and actually closing deals and new LPs can still join in by committing capital for a limited time (e.g., 1 year from first close).• Final close means that when a second threshold has been reach, new

LPs can no longer join in on that particular fund

Exit Stage-How Investors make money?• ROI is generated through:• A) IPO• B) Merger or Acquisition-Sold either in cash or sold

through shares• PE generally buys :• Stable• Niche, Market Leading companies• Non-Cyclical industries

Private Equity Investment Model

PE Firm (GP)

Investors (2)(LP)

Investors (LP)

Fund1

Stable Profitable GrowthSold

Profits

Principal+Hurdle Rate+80% Profits

Invest

Foreign Venture Capital Investment NormsSEBI FVCI Regulations,2000

a) The foreign venture capital investor must disclose its investment strategyand life cycle to SEBI, and it must achieve the investment conditions by theend of its life cycle.

b) At least 66.67% of the investible funds must be invested in unlisted equity shares or equity linked instruments.

c) Not more than 33.33% of the investible funds may be invested by way of:(i) subscription to initial public offer of a venture capital undertaking,whose shares are proposed to be listed.(ii) debt or debt instrument of a venture capital undertaking in which theforeign venture capital investor has already made an investment, byway of equity.

Contd..

iii)preferential allotment of equity shares of a listed company, subject to a lock-in period of one year.

iv) the equity shares or equity linked instruments of a financially weak or a sick industrial company (as explained in the SEBI FVCI Regulations) whose shares are listed.

FEMA(2000) (Transfer of Issue of Security by a Person Resident outside India)• The consideration amount for investment can be paid

out of inward remittances from abroad through normal banking channels.• Subject to RBI approval, a foreign venture capital

investor can maintain a foreign currency or rupee account with an authorized Indian bank

Contd..

• Sectoral limits on Foreign investments in India• Print Media• Atomic Energy• Defense• Agricultural activities• Companies require permission of FIPB before issuing shares to

Foreign VC investors

Tax Consideration for Private Equity Firms

• The income of venture capital companies or funds set up to raise funds for investment in venture capital undertakings is tax exempt, if they are registered with:i) SEBI ii) In compliance with Indian government and SEBI Regulations. • The income of such companies and/or funds will continue to be

exempt, if the undertaking in which its funds are invested, subsequent to the investment, gets listed on stock exchange.

Contd..

• However, tax will be payable by the shareholders of or withdrawers from the company or fund.• Private equity funds are exempt from withholding tax in respect of

income distributed to their investors. The provisions of the IT Act regarding taxation on distributed profits (dividend), distributed income and deduction of tax at source do not apply to these funds.

SEBI-Alternative Investment Funds (Amendment) Regulations, 2015

• Newly created class of pooled in investment vehicles• AIFs are funds incorporated in India • For purpose of pooling in capital from Indian and foreign investors for

investing as per a pre-decided policy.• AIFs are primarily aimed at high net worth individuals• AIFs are private funds which otherwise do not come under the

jurisdiction of any regulatory agency in India.

Which of the following is included in AIF? Yes No1. Mutual Funds 2. Venture Capital Funds3. Private Equity Funds4. Hedge Funds5. Funds managed by registered reconstruction Co.6. Debt Funds7. Infrastructure funds8. Commodity funds

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Alternative Investment Funds CategoriesAIFs are categorised into the following three category:• Category I AIF: • positive spillover effects on economy • certain concessions might be considered by SEBI or GOI.

• Category II AIF: • no specific incentives or concessions are given. • do not undertake borrowing other than to meet the permitted day to day

operational requirements.

• Category III AIF: • considered to have some potential negative externalities in certain situations • Undertake leverage to a great extent• Trade with a view to make short term returns. Ex. Hedge Funds

PRIVATE EQUITY

Investment conditions and restrictions• The PE funds under AIF may raise funds from any investor whether

Indian, foreign or non-resident Indians by way of issue of units• Each scheme of the AIF shall have corpus of at least twenty crore

rupees• The AIF shall not accept from an investor, an investment of value less

than one crore rupees (Employee/Director :25 lakh rupees)• Promoter shall have a continuing interest in the AIF of not less than

two and half percent of the corpus or five crore rupees, whichever is lower• No scheme of the AIF shall have more than one thousand investors• The fund shall not solicit or collect funds except by way of private

placement

• Several financial services organizations have been raising significant amounts of money from Indian HNIs in PE funds. Some being:• Reliance• Birla Sun Life• ICICI• Kotak

Recent in News• Sep 2015: KKR India, the Indian arm of global private equity firm KKR

& Co. Lp, is looking to raise AIF of at least Rs.1,500 crore which will be used to offer credit solution to Indian companies

• KKR India is raising the new fund at a time when demand for funding from non-bank sources is rising for reasons ranging from the• Constrained capacity of traditional state-owned lenders to the • Risk aversion that has seeped into the banking sector due to a growing pile of

bad loans. • To seek credit offerings tailored to their needs even if these come at a slightly

higher cost.

Investment schemes/vehicles & structure of pooling of money

under Private Equity

Investment schemes/vehicles

• A private equity fund is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity.

Contd..

• In a pledge fund, the investors provide a loose commitment of capital to an investment team, the manager of the fund, to make investments within certain preset parameters. Thereafter, the investors must approve each transaction and will decide whether to pursue each transaction independently.

• A venture capital trust or VCT is a highly tax efficient closed-end collective investment scheme designed to provide private equity capital for small expanding companies and capital gains for investors.

Choice of Pooling Vehicle

• The AIF Regulations contemplate the establishment of funds in the form of a trust, a company, an LLP or a body corporate.• The move by the Reserve Bank of India (RBI) to allow foreign

investment into alternative investment funds (AIFs) through the automatic route is likely to boost inflows.

Domestic Funds

• For domestic venture funds (in which the funds are raised within India), the structure that is most commonly used is that of a domestic vehicle for the pooling of funds from the investors and a separate investment adviser for carrying on asset management activities.

Structuring India-focused Offshore Funds

• Private equity and venture capital funds typically adopt one of the following three modes when investing into India:

(1) direct investment in the Indian portfolio company, (2) direct investment in an Indian investment fund vehicle or (3) co-investment alongside the domestic fund vehicle directly in the

Indian portfolio company.

Pure Offshore Structure

Unified Investment Structure

Co-investment/Parallel Investment structure

Hedge Funds

• A hedge fund is an investment fund that pools capital from a limited number of sophisticated individual or institutional investors and invests in a variety of assets, often with complex portfolio construction and risk management techniques.

Hedge Fund Strategies

1. Equity market neutral: These funds attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining long and short positions.

2. Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements

3. Merger arbitrage: Merger arbitrage, also called “deal arbitrage,” seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock.

4.Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated.

Hedge Fund Structure

Types of investors

Fund managers can only accept investment capital from accredited investors or qualified purchasers, including: • Investors • 1. Public employee retirement plans • 2. Corporate employee retirement plans• 3. University endowments• 4. Foundations and non-profit organizations • 5. Family offices and high-net-worth individuals.

Prime Broker

• A brokerage firm provides multiple services to a hedge fund that are beyond the scope of those offered by a traditional broker, such as: • • Clearing and Settlement of Securities Transactions • • Financing • • Recordkeeping • • Custodial Services (oversight of subscription and redemption order

processing) • • Research Capabilities

Executing Broker

• An executing broker is a type of financial dealer or broker that is accountable and responsible for the completion and processing of an order that is requested by a client.

Organizational Structure

The typical hedge fund structure is really a two-tiered organization.

Organisational Structure

• The general/limited partnership model is the most common structure for the pool of investment funds that make up a hedge fund. In this structure, the general partner assumes responsibility for the operations of the fund, while limited partners can make investments into the partnership and are liable only for their paid-in amounts.

Fee Structure

• Management Fee- 1-2%• Incentive Fee - 10-20% of fund profits. The idea of the incentive fee is

to reward the fund manager for good performance. Managers only collect an incentive fee when the fund is profitable, exceeding the fund's previous high - called a high-water mark. This means that if a fund loses 5% from its previous high, the manager will not collect an incentive fee until he or she has first made up the 5% loss.

Graphical Fee Structure

History

•Prior to 2007, the SPV route was available but was not popular as today. Although Mauritius was widely used for investments into India, the Mauritius SPV was not attractive for the following reasons:•P- Notes for Indian Markets was popular at that time. Therefore hedge Funds were getting Indian Exposure by buying P- Notes.•SEBI was granting sub-Account FII very selectively and was excluding hedge fund managers.•The Finance act 2008 came into force and SPV was again included in the definition of an Investment Company. SPV’s can now redeem their shares if they have positive NAV’s.With uncertainity on P-notes future, and SEBI being more willing to grant sub-Account FII to SPVs, the latter became more popular.

Using a Mauritius SPV

•The Mauritius Special Purpose Vehicle(SPV) is becoming increasingly popular in Master-Feeder Structures.•This is mainly attributed to Mauritius having a good treaty network and to the ease and cost of operation in Mauritius.•SPV’s are licensed by Financial Service commission (FSC) in Mauritius as a category 1 Global business company under the financial services act 2007 and are incorporated under the companies act 2001.•The SPV can be set up with multiple classes of shares denominated in more than one currency.

Structure

Setting up an SPV

•The SPV needs to be approved by the FSC before it commences business. In considering an application ,the commission needs to be satisfied about the following:The track record and credentials of the feeder CIS;andThe investment objectives of the SPV and the market targeted.•A condition for the obtention of a Category One Global business License is that the SPV must be controlled and managed from Mauritius.•The SPV must have at least two Local Directors, maintain its Principal bank Account in Mauritius, keep its accounting records in Mauritius, appoint a local Auditor and Provide for meetings of directors to include at least two directors from Mauritius

TAX Benefits

Capital Gains Tax•The DTA transfers the taxing rights on capital gains to the country of residence of the seller, ie Mauritius. Mauritius having no capital gains tax, a complete exemption of capital gains tax is obtained on sale of shares of Indian companies by a Mauritius entity. Dividend Withholding Tax•The Tax Treaty caps the dividend withholding tax for substantial shareholdings to five per cent. Although India has abolished dividend withholding tax, it should be noted that the Indian tax authorities have done so twice in the past decade and had re-introduced dividend withholding tax after a certain period

•Royalties Payable to non-Resident by Category one Global Business Company are tax free•Dividends derived from Mauritius by non resident companies are tax Free

Taxation of SPVs

•An SPV set up to undertake global activities, i.e. activities conducted outside Mauritius, may apply for a Category 1 or Category 2 Global Business Licence (GBL). An SPV structured as a PCC, Société or Trust may only apply for a Category 1 GBL. When organized as a private company, an SPV may apply either for a Category 1 or a Category 2 Global Business Licence. An SPV holding a Category 1 Global Business Licence is taxed at the corporate rate of 15%, but through a generous mechanism of automatic tax credits of 80% the tax rate is brought down to a maximum of 3%. On the other hand, an SPV holding a Category 2 Global Business Licence is exempt from tax. GBL entities have to be set up and managed by a licensed Corporate Services Provider (CSP).

Key Advantages of a Mauritian SPV

Mauritius has a number of features which make it an attractive jurisdiction for the location of SPVs. These include the following:• A plethora of SPV structures • Timing of establishment – 3-7 business days • Minimum capitalisation • Legal system – hybrid (common and civil) • No thin capitalisation rules • Low/Nil Corporate Taxation • No withholding tax • Tax Treaty Network