Private equity and regulatory reforms

I have a piece in today's Economic Time's op-ed on the regulations surrounding private equity, venture capital and the like, it's inter-play with Alternative Investment Funds (AIF) regulations of SEBI and various other laws - particularly tax laws. I argue that while we have made portfolio money easy to deploy, we have made PE/VC kind of money very painful to invest. While portfolio money is good - the contribution of PE/VC kind of investment pools is substantially higher to the economy. We need to make the right changes particularly from a tax angle to make these investment pools attractive, certain and free of regulatory ambiguity. Below is the piece, also linked here (the piece below is slightly longer and more detailed):


It has been only a few months since SEBI introduced the alternative investment fund (AIF) regulations. But its impact has been substantial. SEBI had put out draft regulations last year and received 108 comments (including ours) running into 600 pages. To put it succinctly, the draft regulations would have been an unmitigated disaster which could have brought down the private equity and venture capital industry. And it is a tribute to SEBI that it kept a completely open mind and reworked its regulations based on the comments received. The final product is reasonably free of big picture problems. That is not saying the same thing as there are few big picture problems for these investors.

Clearly India has gone somewhat astray in promoting foreign portfolio money in the form of FII registrations over investment by private equity (PE) and venture capital (VC) money both domestic and foreign. FII registration, investment  and repatriation are incredibly easy and smooth. The Indian markets provide tax free returns on equity whether in the listed space or in the unlisted space - subject to some structuring. By contrast, the investment in the growth engine of corporate India by VC and PE funds has been riddled with roadblocks, uncertainty and Greek pathos. These VC and PE funds take enormous pains at the corporate level. They invest risk capital in companies which banks would not touch with a bargepole with loans or the public markets with equity. Their partners with international operational experience and a good rolodex sit on boards and improve performance and sales of companies. They statistically lose 9 out of 10 investments completely and count on the rare success to return capital. Often the investors lose their shirts while risking so much. They improve the competitiveness of the economy and bring innovation in the process. While they understand these pains and risks, which they must bear in any country, India introduces other pains and other risks which are unnecessary. And when you compare it to the rather painless entry of FIIs in the Indian stock market, it is sad. Sad because we are not promoting the people who promote real business in India. Sad because sweat, blood and tears are not good enough, the government and regulators must impose pointless hoops to jump through for these agents of change.

A major problem for these investors is the lack of a long-term, clear tax policy from the government. This starts with reliance of the domestic pooling structures on trust law, which was not drafted for these kind of investment pools. Tax laws on trusts which were drafted for private family arrangements or for public charitable ones are deliciously vague in their operation in this area. Tax experts rely on various rulings to give comfort of tax pass through status for the investors. But the experts always qualify their opinions of the nature of pass through with a possibly different view. There is also the added uncertainty of whether investment will be categorised as business income or capital gains and the mystery will be solved based on a junior tax officers interpretation of it after a decade and after all investors have been repaid.

Add to this the law of Limited Liability Partnership (LLP) which is expressly permitted as a vehicle of an AIF and even more uncertainty creeps in. While the tax laws are more clear, the FDI policy is not. FDI policy talks of FDI in trusts which are venture capital funds registered with SEBI. However, SEBI only registers AIFs and the VC regulations have been repealed. Even though logic and the law support the reading of AIF in place of VC regulations (relying on another 100 year old law – the General Clauses Act) the clearance from the government agencies for foreign investments in AIFs has been troublesome. Similarly, LLP laws require an in principle approval from SEBI since the fund is registered with SEBI as an AIF, but SEBI does not yet give in principle approvals.

A defect with the AIF regulations is its apparent prohibition to permit investment in real assets like land and building. SEBI should not stand in the way of these pooled vehicles, specially if they are domestic investors who invest in real assets rather than merely financial assets. Such investments harm no one. The investors are sophisticated (over Rs. 1 crore investment), the needs of society are met (with a fresh supply of housing) and financial markets and real markets are better off with investors getting matched with the needs of the economy.

Another important issue is the ban on forward trades in securities which was rooted in a different era when speculation was considered a disease to be wiped out. Unfortunately, the ban is being extended to shareholder agreements with call/put or right of first refusal. These are commercial non speculative agreements and not permitting them would take away some basic protection which such investors are entitled to in all jurisdictions against promoters of a company.

Lastly, the current definition of insider trading is overly broad and implicates honest conduct. For example a due diligence by a private equity player and a subsequent investment would meet all the requirements of insider trading. There needs to be an exception for honest commercial conduct from the overly broad definition of insider trading.

While it is great to have a painless and bureaucracy free FII regime  in India, it is wrong to impose painful standards on investors, foreign or domestic, in the PE and VC space. These investors have earned our respect over the past 15 years (think Bharti Airtel, think Café Coffee Day or thousands of others), it is time we give them their due by just getting out of their way and letting them do their investment without uncertainty and embargoes. That is the least we can do for ourselves.