Brick by brick: India

Debevoise duo Geoffrey Burgess and Maurizio Levi-Minzi outline a financial and business due diligence primer for India-bound fund managers.

Performing business and accounting due diligence in India starts with an appreciation of the unique characteristics of many Indian businesses, caution Geoffrey Burgess, a partner in the London office of Debevoise & Plimpton and his New York colleague Maurizio Levi-Minzi. 

Below the partners provide a due diligence primer specifically around business and financial due diligence best practices: 

Business due diligence

• Foreign investment restrictions: Foreign Direct Investment (FDI) into India is governed by, among other things, the FDI policy of the Government of India, and the inflow and outflow of foreign capital is regulated by the Foreign Exchange Management Act, 1999. While foreign investors are permitted to own 100 percent of businesses in most sectors and can invest via the “automatic route,” which does not require prior approval by either the Government of India or the Reserve Bank of India (RBI), certain critical sectors (such as defense, telecom, insurance and energy) are subject to foreign ownership caps and restrictions, and prior approval from the Government of India or registration and approval from the RBI is required before investing in these sectors. In addition, wholly-owned Indian domestic subsidiaries of non-resident entities are treated as foreign companies for FDI purposes.

• Licenses and approvals: Companies operating in India must navigate an exceedingly complex bureaucracy and a regulatory system with seemingly ambiguous and imprecise rules. Each sector has its own list of licenses and approvals that are required from both the central and state governments. Usually, a financially stable company that has been in business for a while will have its licenses and approvals in order, but there are many companies that do not.

The undue red tape linked to doing business in India has prompted the World Bank to rank its economy 135th out of 183 world economies for “ease of doing business.”  In response, the Government of India and various state governments have recently been aggressively trying to remove regulatory logjams by creating “single window clearances” for setting up businesses in various non-critical sectors. These initiatives to more streamlined approvals should be particularly helpful to companies operating in the infrastructure sector, where development permits take more time than expected to obtain, if they can be obtained at all.

• Corruption: Corruption remains a challenge of investing and doing business in India. The risk is higher in business sectors that operate under governmental concessions or authorisation (sectors such as real estate, infrastructure, telecom and power). It should be noted that many large companies in India are state-owned or controlled, and, therefore directors and employees of such companies are deemed to be “government officials” under the Foreign Corrupt Practices Act and the UK Bribery Act, with the result that payments made to them fall within the laws’ restrictions.

• Corporate governance: Newly-listed companies in India and public companies above a certain prescribed size have to comply with the listing agreement of the stock exchanges, which imposes certain US-style independent director and audit committee requirements. However, the reality is that independent directors do not play the type of proactive role that has become more common in the US and the UK, and are very rarely willing to present conflicting viewpoints from those favoured by the promoters. Importantly, private companies are under no obligation to install any corporate governance mechanisms.

Financial due diligence

• Accounting records: The accounting books and records of Indian companies are sometimes less transparent and reliable than those of US companies. In fact, some Indian companies deliberately keep two sets of accounting records, one for the statutory reporting purpose and the other for internal use. The latter reflects a company’s actual financial condition and results, whereas the former set of records tends to book less revenue and/or more expenditures with a view to reducing the company’s tax liability.

• Financial auditing terms: India does not permit FDI in accounting and auditing services businesses. However, the “big four” accounting firms have established offices in India and offer consultancy services through tie-ups and other arrangements with local partners. It should be noted that many local accounting firms in India may be less credible and impartial in performing audits, as they are more susceptible to pressures from the company as a result of an eagerness to win engagements or maintain existing relationships.

 Accounting standards: Indian companies are required to prepare audited financial statements in accordance with Indian GAAP. The Government of India has proposals pending that would require certain entities including listed companies, banks, insurance companies and other large entities to comply with IFRS. However, these proposals have yet to be enacted.

 Related party transactions: Since many businesses in India are still structured as family-owned conglomerates with a great deal of interdependence, there can be extensive related-party transactions that must be identified and examined.

This condensed article originally appeared in fuller format (including by addressing legal diligence issues) as the second installment from a four-part series in the Debevoise & Plimpton Private Equity Report. Private Equity Manager published the first part titled, “Brick by Brick”, covering Chinese markets, which can be found here