RBI’s New FDI Regime Paves Way for Flexible M&A Structures
Siddharth Singh, Student, Dharmashastra National Law University, Jabalpur
Introduction
The Reserve Bank of India (“RBI”) has recently liberalised the India’s foreign investment landscape through a Master Direction. These reforms not only streamline traditional foreign direct investments (“FDI”) process but also introduce flexibility in mergers & acquisitions activites. By permitting Foreign Owned Companies (“FOCC”) to acquire local firms and enabling local companies to modify the tenor on compulsorily convertible debentures (“CCD”) and preference shares issued to overseas investors, the RBI has redefined the way cross border transactions are executed. Further, by aligning nearly all FDI provisions with downstream investment, transitioning from a rigid payment requirement to a more flexible payment structure, these measures open up new avenues for both listed and unlisted startups to close peer acquisitions swiftly without additional regulatory issues. This article will delve into the pre-liberalisation framework that shaped the traditional investments, outline the new guidelines, and analyse their direct impact on deal structuring and M&A dynamics in India. The author aims to highlight that these changes are set to foster a more dynamic and investor friendly environment in India.
Pre-liberalisation Landscape
Prior to the recent changes, Indian FDI regulatory framework and cross border transactions was marked by several rigidites that limited both the creativity and flexibility of deal structures. The established system required that in most traditional FDI deals, 75% of investments had to be paid upfront while the remaining 25% could be deferred over an 18 month period. However, this payment structure was not uniformly applied. For instance, in downstream investments the entire sum had to be paid in full at the time of the transaction. This created accountable liquidity constraints and reducing the attractiveness of such deals. The framework also imposed substantial limitations on financial options available to domestice and foreign investors. It offered little room for flexibility in structuring transactions such as deferred payments, etc. Investors were required to commit to immediate, full payments for downstream investments curtailing financial arrangements.
Addtionally, lack of provisions for adjustments of tenor of CCD and preference shares limited the ability of the companies to adjust to changing market conditions. In situations when market fluctuations affected share valuations, companies were unable to delay conversion processes resulting in misalignment between market realities and contractual obligations.
These resulted in limiting the scope of peer acquisitions particularly among startups and companies with significant foreign shareholding. A shortcoming of the traditional framework was its restrictive approach to permissible deal structures. For instance, it did not allow for deal structures such as stock-cash arrangements, where a portion of consideration is paid in cash and the remainder through equity shares of acquiring entity. Such hybrid deal structures have potential in cases where liquidity maybe limited but long term value creation through equity is high. This will help in facilitating faster and strategic mergers or acquisitions. By not allowing such an arrangement, earlier regulatory regime has had a hindering effect on mergers.
Liberalisation Measures by RBI
Under the new RBI foreign investment guidelines, FOCCs are now allowed to acquire local companies through the issuance of shares and share swaps transactions. This allows FOCCs to structure deals by exchanging equity instead of relying solely on cash opening up alternative ways for cross border acquisitions.
In addition to this, the RBI has provided local companies with the ability to adjust the tenor on compulsory convertible debentures and preference shares issued to overseas investors. This means that companies can modify the duration of CCDs offering an important degree of flexibility in reponse to changing market conditions. Furthermore, both the domestic investee company and its foreign partner are now enabled to delay the tenor. Delaying the tenor will help if, at the end of the originaly agreed tenor, the fair value of shares is below expected the conversion price. Although such a delay in tenor was permissible under the Companies Act, the RBI has endorsed the same under the Foreign Exchange Management Act (FEMA) ensuring a consistent framework for deferred conversions.
Another major overhaul is the introduction of concept of deferred payment (75:25 rule) to downstream investments. As mentioned previously, downstream investments required payment of full amount at the time of transaction. Now, the RBI has extended the 75:25 payment structure, long established in regular FDI, to downstream investments as well. This will provide with greater liquidity and operational flexibility for transactions under downstream investments.
This flexibility is beneficial for both listed and unlisted startups with over 50% foreign shareholding. These companies can now execute peer acquisitions involving stock and case deals swiftly without needing for additional RBI approvals thereby simplifying transactions. The effect is a more enabling framework for mergers and acquisitions in commercial transactions.
Despite these liberalisations, the RBI has maintained certain restrictions to safeguard national interests. Indian companies owned by investors from land bordering countries remain barred from using their Indian retained earnings to acquire domestic companies. This measure explicitly prevents for entities such as Chinese subsidiaries operating in India from utilising local profits for acquisitions thereby ensuring protection of economic interests. The land bordering restriction is subject to PN3 where the restriction is imposed not only on the immediate investor but also on any ultimate beneficial owner of the immediate investor. This prevents any unintended loophole exploitation through downstream investments.
Impact of Liberalisation on Mergers & Acquisitions
This has transformed the M&A landscape by fostering more deal structures and expediting transaction processes. With the ability to adopt financing mechanisms, companies can now structure deals with a mix of stocks and cash. This approach is preferrable during the periods of market volatility. By using deferred payment options, companies are better positioned to manage liquidity and valuation uncertainties. From a transactional perspective, the extension of flexible payment schemes to downstream investments is a game changer. This adjustment helps reduce administrative delays associated with obtaining regulatory approvals in turn accelerating deal closures. For startups & growth stage companies, it will allow them to function withou being bogged down lenghty procedural hurdles.
Risk mitigation is another notable benefit. The new measures allowing to delay the tenor provide effective hedge against the valuation volatility allowing firms to better align conversion timing with their broader financial strategies.
In broader market dynamics, the shift is expected to be positive. Increased deal flexibility is likely to stimulate higher volumes of M&A activity across sectors especially FOCCs that were required to taken stringent government routes. This will forseeably lead to a market with improved liquidity and deeper capital pools. Investors are anticipated to gain greater confidence in the market owing to additional participation from both domestic and international players.
On a strategic level, companies can now consider mergers and acquisitions as more viable options for growth and expansion owing to such liberalisation and regulatory easements.
Conclusion
In light of such liberalisation, market participants will need to remain agile in response to the evolving regulatory landscape. Companies must reassess their strategic framework and financial models to capitalise on the flexibility allowed in deal structuring. With this shift in regulatory norms, there is an opportunity for businesses to innovate their transaction approaches under such liberalised options to stay ahead in a more competitive market. Such reforms mark a significant step toward establishing India as a dynamic hub for cross border investments and merger. By offering more accomodating environment both domestic and international investors, the changes are poised to attract greater capital flows and foster a vibrant M&A ecosystem.