Legal Structures for Foreign Private Equity in India

Which investment route should foreign investors choose: FDI, FPI, or AIF?

Foreign investors choose their entry route based on their desired level of control, the nature of the target company, and the length of their investment horizon. The Foreign Direct Investment (FDI) route is the most common for PE firms seeking strategic stakes in unlisted companies, while the Foreign Portfolio Investment (FPI) route is designed for secondary market trading with a cap of 10% per entity.

Foreign Direct Investment (FDI)

This is the standard route for long-term strategic investments. It is governed by the Department for Promotion of Industry and Internal Trade (DPIIT).

• Sectoral Caps: Most sectors allow 100% investment under the "Automatic Route," meaning no prior government approval is needed. Restricted sectors like defense or print media require the "Government Route."
• Instrument Types: Only equity shares, fully and mandatorily convertible preference shares, and fully and mandatorily convertible debentures qualify as FDI.

Foreign Portfolio Investment (FPI)

FPIs are registered with the Securities and Exchange Board of India (SEBI). This route is preferred by hedge funds or institutional investors who want liquidity.

• Limits: Individual FPIs cannot hold more than 10% of the total paid-up equity capital of a listed company.
• Reporting: Compliance is managed by Designated Depository Participants (DDPs), making the process faster than FDI.

Alternative Investment Funds (AIF)

AIFs are pooled investment vehicles established in India. Foreign investors can invest in Category I and II AIFs (which include Venture Capital and PE funds) under the automatic route.

• Benefits: Investing through an AIF allows foreign investors to bypass certain individual company-level FEMA restrictions, as the AIF itself is a domestic Indian entity.
• Taxation: Category I and II AIFs enjoy "tax pass-through" status, meaning income is taxed at the investor level rather than the fund level.

How does FEMA compliance and valuation impact equity pricing?

FEMA regulations ensure that foreign exchange enters and leaves India at fair market prices to prevent capital flight. All equity issuances to non-residents must comply with the "Pricing Guidelines" set by the Reserve Bank of India (RBI), which mandate that shares cannot be issued below the Fair Market Value (FMV).

Valuation Norms

For unlisted companies, the valuation must be performed by a SEBI-registered Category-I Merchant Banker or a Chartered Accountant. The valuation is typically conducted using the Discounted Cash Flow (DCF) method or any internationally accepted pricing methodology on an arm's length basis.

• Inward Remittance: The price of shares issued to a foreign investor must be equal to or higher than the FMV.
• Outward Transfer: If a foreign investor sells shares to a resident, the price must be equal to or lower than the FMV.

Compliance Checklist

1. Reporting: Within 30 days of issuing shares, the Indian company must file Form FC-GPR (Foreign Collaboration-General Permission Route) on the FIRMS portal of the RBI.
2. KYC Requirements: The foreign investor must provide Know Your Customer (KYC) documents through their Authorized Dealer (AD) bank.
3. CS Certificate: A certificate from a practicing Company Secretary (CS) confirming compliance with the Companies Act and FEMA is mandatory.

What are the essential SHA clauses for foreign PE and VC investors?

A Shareholders' Agreement (SHA) serves as the primary governing document for a PE investment, outlining how the company will be managed and how the investor can eventually exit. Because Indian company law prioritizes the Articles of Association (AoA), it is critical that all SHA clauses are mirrored in the company's AoA to be legally enforceable.

Critical Clauses for Control

• Veto Rights (Reserved Matters): Investors require a list of "reserved matters" (like changing the business line, issuing new debt, or hiring C-suite executives) that cannot be passed without their specific consent.
• Anti-Dilution Protection: This protects the investor's stake if the company issues new shares at a lower valuation in the future (a "down round").
• Board Nomination Rights: PE firms typically demand at least one board seat and "observer" status to monitor operations closely.

Exit Rights

• Liquidation Preference: In a "liquidation event" (sale or winding up), this ensures the PE investor is paid back their initial investment plus a return before the founders or other shareholders receive proceeds.
• Tag-Along Rights: If the founders sell their stake, the PE investor has the right to join the deal and sell their shares on the same terms.
• Drag-Along Rights: This allows the PE investor to force the founders and other shareholders to sell the company if a third-party buyer offers to purchase 100% of the entity.

How do capital repatriation and tax treaties work in India?

India allows the repatriation of sale proceeds and dividends, but the process is subject to the payment of applicable withholding taxes. The efficiency of an exit often depends on whether the investor can leverage a Double Taxation Avoidance Agreement (DTAA) between India and their home jurisdiction.

Repatriation Process

Once taxes are paid and a "No Objection Certificate" (NOC) or a CA certificate (Form 15CA/15CB) is obtained, the AD bank can remit the funds outside India. Dividends are now taxed at the level of the shareholder at applicable slab rates, usually subject to a 20% withholding tax for non-residents.

Tax Implications and Treaties

Historically, many investors used Mauritius or Singapore holding companies to minimize capital gains tax. However, recent amendments to these treaties mean that capital gains are now largely taxable in India, though some benefits for "grandfathered" investments (made before 2017) still exist.

Should investors choose Indian courts or offshore arbitration?

Dispute resolution is a significant concern for foreign investors due to the backlog in the Indian judicial system, where commercial cases can take over a decade to resolve. Consequently, almost all foreign PE contracts specify institutional arbitration as the preferred method for settling disputes.

Offshore vs. Onshore Arbitration

Most foreign investors insist on offshore arbitration in jurisdictions like Singapore (SIAC) or London (LCIA).

• Seat vs. Venue: The "seat" should be outside India to ensure the New York Convention applies, making the award easier to enforce in India as a "foreign award."
• Enforcement: Under the Arbitration and Conciliation Act, 1996, Indian courts have limited grounds to refuse the enforcement of a foreign arbitral award, usually only on "public policy" grounds.

Emergency Relief

Modern arbitration rules allow for "Emergency Arbitrators" who can grant urgent interim relief (like freezing assets). While Indian law has become more supportive of these measures, it is still vital to draft the dispute resolution clause to allow for interim applications to Indian courts under Section 9 of the Act if the assets are located within India.

Common Misconceptions

"Foreign investors can get a guaranteed return on exit."

This is a myth. Under FEMA, any "assured return" or guaranteed exit price is prohibited. All exits must happen at the prevailing fair market value. Put options are legal, but the exercise price cannot exceed the FMV at the time of exercise.

"100% FDI is allowed in all Indian sectors."

While India is very open, several sectors remain restricted or capped. For example, multi-brand retail, lottery, and gambling are prohibited. Sectors like banking and insurance have specific ownership ceilings and require approval from regulators like the RBI or IRDAI.

"An SHA is automatically binding once signed."

Signing the agreement is not enough. In India, for many provisions of an SHA (like share transfer restrictions) to be enforceable against the company, they must be incorporated into the Articles of Association (AoA). If the SHA and AoA conflict, the AoA usually prevails in the eyes of Indian courts.

FAQs

What is the typical timeline for a PE deal in India?

A standard PE transaction in India takes between 3 to 6 months. This includes 4-6 weeks for financial and legal due diligence, 2-4 weeks for document negotiation (SHA/SSA), and roughly 30 days for post-closing FEMA filings.

Can a foreign PE firm invest in an Indian LLP?

Yes, FDI in Limited Liability Partnerships (LLPs) is permitted under the automatic route for sectors where 100% FDI is allowed. However, LLPs cannot avail of External Commercial Borrowings (ECB) and have different tax treatments compared to private limited companies.

Is "Round Tripping" allowed in India?

"Round Tripping" refers to an Indian resident moving money out of India and then reinvesting it back into India through a foreign entity. The RBI views this with high suspicion and generally prohibits structures that result in round-tripping without specific, prior approval.

What are the reporting requirements for a secondary sale?

When a non-resident sells shares to a resident (or vice versa), Form FC-TRS must be filed with the RBI within 60 days of the transfer of funds or the transfer of shares, whichever is earlier. The responsibility for filing usually lies with the resident party.

When to Hire a Lawyer

Navigating the Indian regulatory landscape requires specialized legal counsel to ensure compliance and protect investment value. You should engage a legal expert when:

• Structuring the investment vehicle to optimize tax and repatriation.
• Conducting legal due diligence on the target Indian entity to uncover hidden liabilities.
• Drafting and negotiating complex Shareholders' Agreements and Share Subscription Agreements.
• Navigating "Government Route" approvals if the sector has FDI caps.
• Managing disputes or enforcing an offshore arbitral award in Indian courts.

Next Steps

1. Sectoral Check: Verify if your target industry allows 100% FDI under the automatic route.
2. Tax Consultation: Engage a tax advisor to evaluate DTAA benefits between India and your home country.
3. Valuation: Obtain a preliminary valuation from a registered Indian valuer to ensure pricing compliance.
4. Draft Term Sheet: Outline the key veto and exit rights before moving to full documentation.
5. Entity Setup: If using the AIF route, begin the SEBI registration process, which can take several months.