The Mysterious World of Global Investors

How they control Indian firms with minority stakes

How much power foreigners wield over businesses that operate in India has never been a matter of complete clarity. Even after Indira Gandhi imposed the Foreign Exchange Regulation Act (Fera) in 1974, forcing multinationals to reduce their holdings in their Indian subsidiaries to 40 per cent—IBM and Coca-Cola were kicked out for non-compliance by the Janata regime in 1977—it was alleged for many years that foreigners retained effective control over these firms. Even with minority ownership, critics said, they held veto power over all crucial decisions taken by local managements via a series of informal agreements.

Post-liberalisation, now that MNCs and other global investors are welcomed with open arms by India in most business sectors, foreigners are majority shareholders in hundreds of Indian companies. In turn, Indian business houses own global brands like Jaguar and Novelis; even what’s left of what was once the mighty East India Company has been bought by an Indian. Attitudes to globalisation have changed. But still, misgivings remain.

Many suspect that foreign investors, even with minority ownership, wield more clout over Indian businesses than it appears. Apart from MNCs and  foreign institutional investors (FIIs), there are those that maintain a low profile. Hedge funds, which move trillions of dollars across borders with little hesitation, attracted attention after the turbulence of 2008. But there are also private equity (PE) funds, which strategically deploy their money in fast-growing companies across the world. In 2010, PE accounted for over $7 billion of India’s foreign exchange inflows. Among the biggest such investors is DE Shaw, an American PE fund with global capital of $21 billion. It alone has invested over a billion dollars in Indian firms, both those that are publicly traded on stockmarkets and those that are not.

As Indian businesses woo capital and global investors seek high returns in emerging markets, privately negotiated deals are on the rise, with PE funds buying minority stakes but operating as ‘strategic partners’. This often means that their money comes along with management advice and strings attached that bind these local companies to their goals.

Typically, the broad aim of a PE fund is to help a business expand and then exit at a neat profit after a period specified by the deal (say, five years) by offloading shares in some way. In line with the plan, expansive clauses on ‘special rights’ are woven into the contract that let it veto business decisions, even on crucial issues of ownership and effective control.

There is thus the likelihood of a conflict between promoters and PE firms. Indian corporate law is vague about the rights of minority institutional shareholders (especially foreigners), and the stockmarket regulator Sebi is undecided on whether such ‘special rights’ constitute management control. As a result, such tussles either go for private arbitration or end up in court, depriving India of an open debate on a matter that influences investment inflows.

Gleaning agreements inked between majority promoters and minority PE partners, confidential letters written by both parties to the Reserve Bank of India (RBI) and Foreign Investment Promotion Board (FIPB), and assorted court documents, Open lifts the veil of secrecy over such deals. What emerges is a shadowy world of global financiers so convinced of the power of their capital, that they seem to give the niceties and spirit of partnership short shrift.

To meet their own profit commitments to their shareholders back home, PE funds need every pick in India to come good. So they set well-defined targets for returns on their investment: both in terms of annual dividends and gains in their shareholding value. These goals risk being missed if the company invested in is mismanaged and runs into losses. For an unlisted firm, their preferred exit option is an initial public offering (IPO), which could be delayed or derailed for other reasons as well: another risk.

Normally, equity investors simply bear such risks. But in these PE contracts, the returns are not just ‘targets’ but money that is due—as incorporated in agreements signed between majority owners and PE investors; these are calculated on the basis of an interest rate of 10–25 per cent compounded annually, a la debt. “There is nothing wrong or illegal about fixed returns, even on equity instruments,” avers Gopal Jain, managing partner, Gaja Capital, “After all, the owners have signed binding agreements with private funds.” Others emphasise that this is an accepted norm globally.

The ‘fixed returns’ clause has another advantage. Since the money is invested as equity (not debt), and routed through an offshore entity based in Mauritius, with which India has a double-taxation avoidance treaty, the foreign investor does not pay capital gains tax when it encashes its chips. “When DLF bought back the minority stake of DE Shaw in one of its subsidiaries,” says someone involved in the deal, “the foreign fund got an official letter from the Income Tax Department stating that there was no need to deduct tax at source.”

But how is the ‘fixed return’ clause enforced? The answer lies in the vulnerability of promoters to pressure on vital matters of management. Read on.

In most deals with unlisted companies, foreign investors have the right to appoint a few directors to its board, who, together with the mandatory independent directors, constitute a majority. As a back-up, the contracts categorically grant veto power over crucial decisions to directors nominated by the minority shareholder.

For example, a letter dated 5 May 2011 written by DE Shaw to the FIPB listed 24 ‘affirmative vote rights’: issues on which the nod of its appointed directors was essential. In the case of Amar Ujala Publications, in which DE Shaw invested Rs 117 crore in 2006 to buy an 18 per cent stake, these included vital issues like mergers and acquisitions, changes in share capital, minor alterations in approved business plans, payment of dividends, and the launch of new products and promotional activities with expenses exceeding Rs 5 crore. ‘There is nothing unusual or special about these rights,’ contended the letter, ‘These rights are commonly provided to private equity and financial investor…. The grant of such rights, particularly in the context of private or unlisted companies, is not prohibited by any law or the FDI (foreign direct investment) policy, including [India’s] print media guidelines and Foreign Exchange Management Act.’

However, in the recent past, Indian courts have deemed some of them untenable. In fact, says Sanjaya Kulkarni, a Mumbai-based consultant, “It is because of these legal precedents that most PE investors force promoters to include these rights in the Articles of Association (AoA) of the company. The courts have maintained that whether these rights are granted in listed or unlisted companies, as long as they have been accepted and cleared by all shareholders, as AoA changes have to be, there is nothing wrong with them.”

In listed companies, however, such affirmative rights of minority shareholders are considerably weaker. “One reason is that all minority shareholders have to be treated the same. One cannot distinguish between different sets,” says Prithvi Haldea, whose firm, Prime Database, tracks PE deals. Another reason is that global investors are wary of being accused of bullying company boards.

Another typically suffocating clause states that if the majority owner sells even a part of his shares to anyone, the PE investor has the right to ‘tag-along’; that is, it can choose to sell its shares, partly or entirely, in the company to the same buyer at the same price.

Similarly, by another clause, if the majority owner is unable to launch an IPO and refuses to pay the fixed return, the PE investor can then exercise its ‘drag along’ right. It can sell its stake to any potential buyer/s it finds, including rivals, and force the original promoters to sell out at the same price.

This was the crux of the bitter dispute—currently in court—between DE Shaw and Amar Ujala. In October 2010, DE Shaw exercised its first exit right, and asked the Maheshwari family, majority owners of the newspaper, to pay the fixed return (25 per cent compounded) along with its original investment. In response, Atul Maheshwari, former managing director of the Amar Ujala group, called the agreements he had inked with DE Shaw “illegal”.

Stung, the foreign partner wrote another letter, dated 15 December 2010, asking Maheshwari to transfer his and his family’s shares to an ‘escrow/designated account (acceptable to DE Shaw) as contemplated by the Exit Rights Agreement’. The PE fund then approached potential buyers—market rumours suggest preliminary talks with the Hindustan Times and Dainik Bhaskar groups—to fix a price for the sale of Amar Ujala.

Angered by this and scared of losing ownership of his business, on 21 December 2010, Maheshwari asked the Amar Ujala board to declare the agreements ‘void ab initio’ and change the company’s AoA. On 4 February 2011, a day before the board could take up the matter, DE Shaw got an interim order from the Company Law Board (CLB) that restrained it from passing any resolutions that could hurt the interests of the foreign minority shareholder. Even as the CLB was hearing the case, DE Shaw filed a petition in the Delhi High Court in March 2011 to stop the Maheshwari family from selling any of the company’s assets. Both the CLB and High Court are now involved.

This legal battle could set a precedent on what powers a foreign strategic-but-minority partner can wield in an Indian company. It may also answer the crucial question of whether negative control—as exercised via veto power—can be construed as positive.

Also at stake in this case is the sanctity of agreements signed privately between majority Indian owners and minority foreign shareholders. If the judgment favours the Maheshwari family, it could deter private equity inflows. If it goes against them, Indian promoters may have to reconsider their ardour in wooing foreign capital. Either way, the cause of globalisation will suffer.

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