FDI policy tweak may squeeze Chinese investments into MSMEs, startups

Credit and Finance for MSMEs: Considering the present scenario and aftermath of Covid-19 pandemic, availability of capital for both MSMEs and startups will be crucial for their survival.

FDI norms, neighbouring countries, china, COVID-19 pandemic, FDI proposals, FDI flows, latest news on FDI
  • By Vinayak Burman & Hardik Thakker

Credit and Finance for MSMEs: “Chaos in the world brings uneasiness, but it also allows the opportunity for creativity and growth” -Tom Barrett. With notification of Press Note (PN) 3 (2020 Series) by the Department of Promotion of Industry and Internal Trade on April 17, 2020, the government of India has adopted the route which developed countries in the world such as United States of America, Germany, Australia, have undertaken to keep a check on foreign direct investment from particular jurisdictions/countries in the world. Without specifying names, the government through PN 3, has notified that any investment into India by citizen/entity resident of the country that shares a land border with India (neighbour countries) or the beneficial owner of the entity investing in India being from such neighbour countries can invest only under the government route (approval route).

The existing foreign direct investment policy of India already has restrictions vis-à-vis investment from Bangladesh and Pakistan. Pursuant to PN 3, investments from Afghanistan, Bangladesh, Bhutan, China, Nepal and Myanmar are now additionally subject to approval route. A major impact of this will certainly be for investments which India attracts from China.

The intent expressed by the government while notifying PN 3 is to curb opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic. Japan earmarking approximately $2.2 billion for Japanese manufacturing firms to leave China and relocate back to Japan or to any other countries in South East Asia, People’s Bank of China increasing its stake in HDFC Limited, concern raised by MSME sector fearing aggressive takeover/buyout of controlling stake at low valuations, are some of the factors contributing to notification of PN 3. Although China seems to have retorted this action, there is indubitably an urgency to put necessary checks and balances under the current foreign direct investment regime in India, considering various sectors wherein 100 per cent investment is allowed under the automatic route. PN 3 poses interesting scenarios to look into.

Dissuading Investors

Both the MSME Sector and the startup space in India have seen a decent inflow of FDI from China. MSMEs contribute around 29 per cent of the GDP. Chinese portfolio investment in startups like Ola, Swiggy, Paytm, OYO and Snapdeal is now valued at more than $6 billion. Around 18 of the 23 unicorns in India are backed by Chinese investors. Marquee names like Alibaba, Fosun, Shunwei Capital, Tencent have their investments in various startups.

Considering the present scenario and aftermath of Covid-19 pandemic, availability of capital for both MSMEs and startups will be crucial for their survival. Disruptions in the supply chain due to Covid-19, have forced the companies across the globe to de-centralize their supply pipeline and look out for countries other than China. India is certainly in a unique position to leverage this opportunity. MSME sector and startups will certainly be key drivers here for India. Availability of capital to leverage this opportunity will play a critical role. PN 3 currently is silent on the key distinction of investment being strategic/majority stake vis-à-vis being purely financial/minority stake in the Indian companies. Financial investment or minority shareholding being subjected to a cumbersome and time-consuming process, under the approval route, may certainly dissuade a financial investor and also impact several startups for whom this was a relevant source of capital.

Beneficial Ownership

PN 3 also dwells into the angle of ensuring that the investment in India by an entity wherein the beneficial ownership resides in such neighbour countries will also be subject to approval route. The term ‘beneficial ownership’ is not defined in the PN 3. Nuances of ‘beneficial ownership’ under the Companies, Act, 2013, regulations prescribed by Reserve Bank of India, SEBI and under the Prevention of Money-Laundering Act, 2002, are very different. It will be important to have clarity on the relevant applicability in this case as well as in relation to any transfer of shares of an Indian investee company by any investor to any investment vehicle or holding company based in any jurisdictions where the grand-fathering structure could bring a layering presence to ultimate holdings being from such neighbour countries.

PN 3 also covers a situation wherein “transfer of ownership of any existing or future FDI in an entity in India, directly or indirectly” results in significant beneficial ownership falling in such neighbour countries would be under the approval route.

There are other countries in the world such as Mauritius, Singapore, Hong Kong, etc. that contribute higher direct investment numbers in India when compared to investment by entities in China. With the construct of beneficial ownership encapsulated in PN 3, funds and collective investment vehicles across the globe investing in India with limited partners, whether as co-investors or otherwise in such neighbour countries, could also come under the purview of approval route.

Clarity on all these aspects will be important and hopefully be addressed when necessary amendments to the Foreign Exchange Management (Non-Debt Investment) Rules, 2019, consequent to PN 3, are notified or relevant other clarifications are provided. PN 3 has certainly set a tone for changes in the dealmaking and foreign investment scenarios in India going forward.

Vinayak Burman is the Managing Partner and Hardik Thakker is the Senior Associate at Vertices Partners. Views expressed are the authors’ own.

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