In reality, there is nothing "back-door" or covert about the recent liberalisation of foreign investment rules pertaining to AIFs. The new rules simply lay down the red carpet for foreign investors to make a grand front-door entry into the booming Indian start-up space.
The facts are simple. In November, shortly after it announced a package of measures to relax sectoral foreign direct investment (FDI) restrictions, the government liberalised the ground rules for AIFs operating in India.
The changes were threefold. AIFs investing in India were allowed to receive contributions from overseas investors without prior approval from the Foreign Investment Promotion Board. The AIF vehicle was green-flagged for NRI investors, who remit about Rs 8 lakh crore annually into bank deposits in India. And most important, downstream investments by India-sponsored and managed AIFs, whatever be their mix of rupee and dollar funds, were exempt from all sectoral FDI caps and conditions. This means that such AIFs can now pool in dollars to redeploy them into FDI-restricted sectors such as e-commerce, multi-brand retail trade or defence.
These sectors, due to their mandated need for, and yet non-availability of domestic capital, have had to take recourse to multi-layered holding companies to appear as Indian-owned, even as their capital is actually pooled in Singapore or Mauritius. Thanks to the disentangling of these rules, Indian AIFs may also witness manifold expansion in their capital flows.
Quick number-crunching based on industry and Securities and Exchange Board of India data shows that in the first nine months of 2015, Indian asset managers invested about $2.45 billion in domestic opportunities, with nearly two-thirds of that money routed through offshore structures. With the simplification, domestic AIFs (who invested $850 million) can easily see their assets treble, translating into a total commitment of $7-8 billion that will make it to Indian shores.
The opportunity could be much should the Centre eventually consider further liberalisation of its AIF rules that allow India-focused foreign firms to sponsor or manage vehicles here. Besides boosting further flows, the move is critical for nurturing local fund management talent - the lifeblood of the fund management business.
With the definitions of AIFs "managed" and "sponsored" in India clearly laid out, AIF managers can use simple operating structures. They will no longer have to lead a make-believe life as "offshore" investors, with operations artificially located in Mauritius or Singapore and convoluted mechanisms to prove that "decision-making" resides there. This will result in a welcome trend of more AIFs onshoring their operations to India.
Fund management, in the AIF context, is a hands-on activity. Value creation for venture capital/private equity investors rests wholly on the ability of the general partners (fund managers) to actively participate in the strategic and management decisions of their investee firms over five to seven years so that they can drive scale and better governance practices.
Today, India's start-up economy is thriving because it has hundreds of intrepid entrepreneurs with disruptive ideas, keen to strike out on their own. For the best ideas among these to win, we also need a pool of capable managers who can sift the true innovators from the also-rans. That can only be achieved if AIFs are incentivised, as they are now, to "manage" in India.
The impression that relaxing the rules for AIFs somehow gives a privileged set of foreign investors a back-door entry into FDI-restricted sectors such as e-commerce, multi-brand retail or defence is also wrong. History shows that as a source of capital flows into the country, foreign portfolio investors can be quite mercurial. Running a standard deviation analysis of foreign institutional investor flows into India in recent years shows that they have been about 14 times as volatile as the Nifty! While portfolio investors may base their commitments or pullouts on a short-term view of currency and market movements, AIF investors per force lock in their investments for five to seven years.
Going by experience, this means assuming a 50 to 60 per cent risk to capital on rupee depreciation alone. Add to this the illiquidity needed for AIF investments to mature into distribution, and there's an overall risk premium of 70 to 80 per cent that AIF investors are called upon to bear. In return for taking on this extra risk on illiquidity and exchange rates, there seems to be no harm in extending some concessions by permitting AIF investors to invest in restricted sectors.
If you look at some of the most successful multinationals in India, many have their origins in the relaxations made by the Foreign Exchange Regulation Act (Fera) in the 1970s. In 1973, in a fit of nationalist sentiment, Fera rules forced all multinationals stationed in India to dilute their foreign ownership and cap their parental equity stakes at 40 per cent in their Indian arm.
Wiser counsel prevailed even then and multinationals operating in technology-intensive, export-intensive and core-sector industries were allowed to retain higher ownership stakes of 74 per cent. A selective licensing regime was instituted for technology transfer and royalty payments and applicants were subjected to export obligations.
We live in far more enlightened and liberal times. Any move to throw open the doors for long-term foreign investors who can bring in technology, skill and dollars into our capital-starved economy deserves celebration, rather than censure.
The writer is chairman, TVS Capital Funds Ltd, and vice-chairman, Indian Venture Capital Association