This article was originally published in The Indian Business Law Review, Volume 2, Issue 1, ISSN: 2583-8148. For more insightful articles, please visit https://iblronline.com/volume-2-issue-1/.

Background

Private equity investors acquiring portfolio companies (“Target”) through affiliated acquisition vehicles (“Acquirer”) typically look for the Targets to continue being run by existing (strong) management teams (which in the Indian context, generally includes the Indian resident founders and/or owners, who are resident in India) (“Founders”) who, along with officers appointed by the Acquirer, can continue running the Target after acquisition and provide the financial investor with a profitable exit.

One of the most common ways private equity funds, particularly based out of the US, achieve the continued support and ‘skin in the game’ of the Founders in the acquired Target is by way of a ‘rollover’ investment by the founders/ sellers. In the Indian context, a rollover investment refers to the re-investment by the Founders of a portion of their purchase consideration for purchase of equity interests of an offshore entity (“Rollover Target”) in the investor’s ownership structure, which is typically a holding company aimed at holding several investments made by the investor. Such Rollover Target is also the entity where management of the investor and other founders of acquired portfolio companies would typically invest or be offered stock options.

This note sets out the key regulatory considerations under Indian exchange control regulations, for rollover investments by Indian Founders into an offshore Rollover Target, following the acquisition of the Indian Target by an offshore Acquirer.

Key Regulatory Considerations for Rollover Investments

• Rollover Investment via Reinvestment of Purchase Consideration: Globally, rollover investments are usually structured as allotment to Founders of equity interests in Rollover Target as a part of the consideration for sale of their securities in the Target. However, Indian exchange control regulations do not permit Indian resident individuals to acquire securities of offshore entities (such as a Rollover Target) by way of a swap and as consideration for sale of their securities in an Indian Target. Accordingly, Founders must, post receipt of their consideration, re-invest a portion of such consideration, to subscribe to equity interests in the Rollover Target.
• Overseas Direct Investment (ODI) and Overseas Portfolio Investment (OPI): Re-investment offshore (i.e., overseas investment) by Indian Founders can primarily be made under either ODI or OPI routes. Investment in unlisted equity capital of a foreign entity or investment in 10% or more of the paid-up equity capital of a listed foreign entity or investment with control in the paid-up equity capital of a listed foreign entity is considered as ODI investment under Indian exchange control regulations. Investments of less than 10% in the listed foreign entity would be considered as OPI investments (there are certain other deemed OPI investments where Indian employees of a foreign entity may receive stock options in such entity subject to certain specified conditions, but that is not the topic of discussion under this note and will be covered separately in a different note).
• Identification of the Rollover Target: To enable the Founders to benefit from the financial investor’s entire investment portfolio (and not just the Target), an entity high-up in the ownership chain, which directly or indirectly hold all (or a majority of) the financial investor’s portfolio companies, is generally chosen to be the Rollover Target. When a Rollover Target is identified, the following considerations are key, as they affect the structures and options available for overseas investment by Indian Founders under Indian exchange control regulations:
• Is the Rollover Target engaged in a bonafide business activity?

Any overseas investment can only be made in a foreign entity engaged in a ‘bonafide’ business activity, i.e., any business activity permissible under any law in force in India and the host country or host jurisdiction. Accordingly, overseas investment is not permitted in foreign entities not engaged in bone fide business activities.

• Is the Rollover Target engaged in ‘financial services activities’?

‘Financial services activities’ means activities, which if carried out by an entity in India, require registration with, or will be regulated by, a financial sector regulator in India. One such class of entities requiring registration from, and regulated by, the Reserve Bank of India are ‘non-banking financial companies’, i.e., companies whose financial assets constitute more than 50% of their total assets and whose income from financial assets constitutes more than 50% of their gross income. A Rollover Target directly or indirectly holding all/a majority of the financial investor’s portfolio is, in our experience, likely to breach the aforesaid 50-50 threshold and accordingly be deemed to engage in financial services activities. These entities are also typically unlisted entities abroad. As set out below, whether or not the Rollover Target is engaged in financial services activities is an important factor in determining the structure for the rollover investment by Indian Founders.

• Identification of the Rollover Investment Entity: As mentioned above, Indian exchange control regulations do not permit Indian resident individuals or Indian entities to invest in foreign entities that do not have any bonafide In addition, Indian resident individuals (such as the Indian Founders) also cannot undertake ODI investment in entities engaged in financial services activities.

On the other hand, an Indian entity, such as a company or LLP (“Indian Investing Entity”), is permitted to make ODI investment in the unlisted Rollover Target engaged in financial services entity, subject to specified conditions. If the Indian Investing Entity is itself not engaged in financial services activities, then such ODI investment may be undertaken if it has posted net profits in the last 3 financial years. Further, if the Indian Investing Entity is engaged in financial services activities, then such ODI investment may be undertaken if the following conditions are met: (i) such Indian entity must have posted net profits in the last 3 financial years; (ii) it is registered with or regulated by a financial services regulator in India; and (iii) such Indian entity has obtained approval from regulator(s) of such financial services activities (both Indian and offshore, as applicable), for engaging in financial services activities.

The investment by such Indian Investing Entity is also subject to the condition that the total investment made in all foreign entities taken together at the time of investment cannot exceed (i) 400% of its net worth as of its last audited balance sheet; or (ii) USD 1 billion, whichever is lower.

Therefore, if the Indian Founder controls such an Indian Investing Entity, such entity (“Rollover Investment Entity”) may be used to make the ODI investment in the Rollover Target, subject to fulfilment of the conditions set out above. If the Rollover Target is an unlisted operating entity, not engaged in financial services activities, then Indian resident individuals (such as the Indian Founders) may invest up to USD 250,000 (or equivalent) per financial year by way of ODI investment directly in such Rollover Target under the liberalized remittance scheme formulated by the Reserve Bank of India.

• Round-Tripping: Whilst investments resulting in round-tripping of funds invested from India was explicitly prohibited under the previous Indian overseas investment regime, the new regime effective from August 22, 2022, has relaxed such constraints. The new regime now allows Indian persons to invest in an offshore entity (such as the Rollover Target) that has, directly or indirectly, invested or invests into an India entity, if the resulting investment structure is limited to 2 layers of subsidiaries of the Rollover Target. In other words, the new regime permits a direct or indirect investment by the Rollover Target into an Indian entity, provided that there is only 1 subsidiary between the Rollover Target and Indian entity (for example, the Target). Structure 1 and Structure 2 below provide illustrative examples on permissible and impermissible structures, respectively:
• Valuation, Payment and Reporting of Overseas Investment: The Indian Founder or Rollover Investment Entity, as the case may be, can make payment towards overseas investment by remittance through normal banking channels (and certain other permissible means). It must be noted that the overseas investment must be made at an arms’ length price, based on a valuation report prepared using an internationally accepted pricing methodology.

Reporting of ODI investment must be done in Form FC, by the person resident in India (i.e., Indian Founder or the Rollover Investment Entity, as applicable) at the time of undertaking outward remittance or financial commitment, whichever is earlier. Reporting of OPI investment needs to be done in Form OPI, within 60 days from the end of the half-year (i.e., September or March) in which such OPI investment is made. Set out below is an illustrative list (and not exhaustive) of documents typically required by authorised dealer banks along with the Form FC/Form OPI. It must be noted that each authorised dealer bank may also have their own requirements to process overseas investment filings, which may include information/documents in addition to the following:

• A board resolution passed by the Rollover Investment Entity approving the investment;
• A valuation report certifying the price arrived at for the overseas investment at an arms’ length basis;
• A letter containing key terms of the investment agreement executed for the overseas investment;
• The certificate of incorporation or equivalent document of the Rollover Target;
• The memorandum of association or equivalent document of the Rollover Target, required to ascertain the business of the Rollover Target or alternatively, a letter from a CPA certifying the business activities carried out by the Rollover Target;
• The latest audited financials of the Rollover Target; and
• The approvals, if any obtained by the Rollover Target for the overseas investment or alternatively, a letter from a CPA certifying that no such approvals are required.

Additionally, where the Rollover Investment Entity has made ODI investment, it must also submit (i) an Annual Return on Foreign Liabilities and Assets to Reserve Bank of India on or before 15^th of July of each year; and (ii) an Annual Performance Report in with respect to the Rollover Target, every year the Rollover Investment Entity is invested in the Rollover Target, by December 31, only if it is holding 10% or more of the equity capital without control in the Rollover Target and there is no other financial commitment other than by way of equity capital in the Rollover Target.