India guaranteed return clauses: No sure things

The challenges faced by entrepreneurs are typically viewed from the perspective of those helming young start-ups. But the apparent suicide earlier this year of V.G. Siddhartha, founder of India's Coffee Day Enterprises, shows that even a widely respected industry veteran with a thriving business can still fall victim to self-doubt and feel he has "failed as an entrepreneur."

The Coffee Day situation has raised specific questions about the relationship between founders and private equity firms, especially when interests become misaligned. Siddhartha's last letter to his board referred to an unnamed PE investor that forced him into a share buyback for which he had to borrow a large amount of money from a friend. Siddhartha's cited this, plus several other sources of financial and personal pressure, as factors that led him to conclude there was only one way to end his misery.

The full details may never be known. However, industry observers say that there have been plenty of examples over the years where GPs with guaranteed minimum return clauses in their investment agreements have required that founders put personal finances on the line to honor these deals. The vast majority of these cases do not have such extreme outcomes, but they still tend to distract founders precisely at the times when their full attention is needed.

"We have exposure to an entrepreneur in India who has some of these structures in place. He constantly tells us that, while they seem very interesting when valuations are good, they put a high strain on cash flow generation as well as curtailing his ability to think about growth in a non-linear fashion," says Chetan Gupta, a managing director at Samena Capital. "You always have to worry about taking two steps forward and then faltering and not being able to meet those obligations." 

Pressure on entrepreneurs linked to guaranteed return clauses is becoming less common as India's private equity industry matures, but Coffee Day serves as a reminder that some GPs tend to escalate their demands where a softer touch is needed. It is a difficult balance to strike. On one hand, finding a way to maintain alignment with founders is preferable to playing hardball with contractual agreements. On the other, if alignment cannot be restored, they must pursue the best outcome for their investors.

Problems of the past

For many, the aggressive administration of guaranteed return clauses comes from another era, when a wave of newcomers to India relied on familiar structures, imported from developed markets, to safeguard their investments. The thinking was that by committing founders to buy back shares at a guaranteed price, investors would be able to ride out any bumps in the road associated with emerging markets. It wouldn't take long for the shortcomings of this idea to become apparent.

"There were a lot of deals prior to 2008 that were done using those instruments," says Amit Gupta, a founding partner at NewQuest Capital Partners. "They really came to a test in 2010-2015, when capital markets weren't so good, IPOs were not happening, and a lot of investors wanted to use the guaranteed minimums to get their IRR. But the track record of enforceability hasn't been that good."

One of the biggest stumbling blocks for enforcement at the time was the regulatory view that these structures represented an attempt by investors to shirk the risk that comes with taking an equity interest in a company. Numerous company founders helped convince regulators – already skeptical of private equity as an asset class – that foreign GPs were trying to get debt-like guarantees with equity returns, and taking advantage of inexperienced Indian entrepreneurs in the process.

This perspective has been challenged by some industry participants, who point out that the limited investment horizon of private equity players, and hence their need for timely exits, has always been well understood in India – if not by founders then by the lawyers that help them negotiate deals. Pratibha Jain, a partner at Nishith Desai Associates, says she has never taken part in a negotiation that did not involve a commitment from founders to help provide an exit to backers.

"What is non-negotiable for private equity investors, and we tell the promoters up front, is that their exit rights will be unfettered," says Jain. "They may have a put option, or a right to sell and drag the promoter to sell with them, or the right to appoint bankers to take the company public. All of these rights may be put in to provide them that mandatory exit they will need at the end of the fund life."

Execution issues

Regardless of who is in the wrong, the historical sympathy between company founders and regulators means that on a practical level the deck has always been stacked against GPs trying to enforce their rights. While most Indian entrepreneurs are conscientious about trying to make things right for their investors, many private equity firms have found out the hard way that if a promoter doesn't care to help them, there isn't much they can do to force his hand.

"In some cases, founders have taken a pretty hard stance and said, ‘You took equity risk, and if it's not working out for you, I can't be held responsible,'" says Newquest's Gupta. "Those situations may drag on for years, which can mean a delayed exit as well as founders getting distracted from running the day to day business."

The practical difficulties associated with guaranteed minimum return clauses have contributed to a decline in their popularity. Agreements now may include a pro forma right to force an exit, but investors have largely lost interest in establishing specific target returns that are unlikely to be met.

Still, the remnants of earlier structures are visible in the market; as a specialist in secondary deals, Newquest often comes across these clauses when buying stakes from other GPs. Counterparties often try to use the guaranteed return as a bargaining chip when pushing for a higher price, but history has taught Newquest to put little value on such promises. It sometimes removes these requirements so that the founder can focus on growing the business without trying to hit an arbitrary target.

"When we're buying a stake from another investor, we may inherit the guaranteed minimum," Gupta explains. "But our underwriting isn't based on that – we underwrite based on the value of the company today, and we think in terms of equity risk rather than depending on the guaranteed minimum clause to make our return."

In situations where the clauses persist, from a business perspective it can be difficult to fault investors for attempting to put them to use. This is especially true when a fund is nearing the end of its life, the GP hasn't delivered much in terms of realizations, and LPs are agitating for returns. 

Even when entrepreneurs are willing to work with GPs to honor their agreements, expecting them to live up to a paper guarantee is considered highly naïve. Entrepreneurs can try to raise the capital to buy back the GP's stake by leveraging their own equity in the company for a bank loan, but this has become harder in recent years as the financial system struggles with non-performing loans (NPLs). Last year's liquidity squeeze among non-banking finance companies (NBFCs) exacerbated the situation.

In the absence of traditional financing avenues, promoters can go to outside sources such as family or friends – as Coffee Day's Siddhartha did. But this has the inevitable result of increasing the burden on founders at both a personal and a business level, which can lead to unpredictable consequences.

Changing perspectives

Many in India's PE community have recognized the shortsightedness of ratcheting up pressure on the leader of an underperforming business. While Coffee Day example is a cautionary tale for GPs – bearing in mind that the precise role played by private equity in Siddhartha's difficulties is still unknown – it is generally accepted that giving portfolio companies space to work out their issues is more productive than breathing down their necks.

"I haven't seen too many situations where a PE investor has actually dragged a promoter to court to enforce the minimum threshold clause," says Nitish Poddar, India national leader for private equity at KPMG. "One reason is that the legal system in India can take 15 years to decide a case; another is that from the standpoint of market reputation an investor doesn't want to be seen doing that." 

Nevertheless, industry participants do not rule out the possibility of friction with promoters over guaranteed minimum return clauses. Indeed, some see it as an inevitable byproduct of another cycle of investments where exits are less assured than GPs had originally thought. 

The hospital space is seen as a likely site for such hard lessons. Many recent deals have incorporated guaranteed return clauses, which investors say are justified because healthcare demand is stable and non-cyclical; but this assessment overlooks the difficulty of building a new hospital brand. It remains to be seen whether investors find their contractual rights are of any help when looking for liquidity. 

"To your investment committee it might sound like a great thing to have, but how are you going to enforce it?" Gupta says. "In India, even a simple fair market value put can be difficult. A couple of these deals have worked well here because the underlying businesses have swung around sharply, but to superimpose that template on other businesses is very risky. If it goes bad, I think the investors are as much, if not more to blame, than the entrepreneur."   

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• Topics
• South Asia
• Advisory
• GPs
• Regulation
• India
• Samena Capital
• NewQuest Capital Partners
• KPMG