By Santosh Pai & Vivan Sharan
A revision to India’s foreign direct investment (FDI) policy in April, primarily directed at China, requires investors from bordering nations to apply for prior government approval. Press Note 3 was originally meant to prevent opportunistic takeovers during the Covid-19 pandemic, but after the border fracas in Ladakh it became a tool to exert economic pressure on China. Despite hundreds of applications from Chinese investors, approvals are not forthcoming. The measure was a useful short-term tactic in bringing Chinese investments to a standstill. However, after five months, its effectiveness is wearing thin.
Start-up founders and their Chinese backers are increasingly exploring investment structures that will circumvent the need for FDI approval. This is not surprising since China was among the fastest-growing sources of inward FDI and Chinese investors have invested in a majority (60%) of local unicorns.
Indian FDI restrictions follow the Chinese playbook to keep foreigners from controlling local companies. Chinese FDI rules from 1995 first divided foreign investments into four categories: encouraged, allowed, restricted and prohibited.
Even today, over 30 types of investments are classified as either restricted or prohibited. These rules disallow foreign ownership of companies in industries like telecom, internet, media and education. Despite such restrictions, a Chinese internet news company called Sina raised foreign capital through a ‘Variable Interest Entity’ (VIE) structure at the turn of the century. Subsequently, over 150 Chinese companies have used this structure, now common knowledge in China.
Over the last 20 years, leading tech giants like Alibaba, Tencent and Baidu have used lawyers in the US and China to perfect the VIE structure over successive rounds of capital raises. Scores of Chinese companies raised large amounts of capital from American investors in exchange for ‘contractual rights’ rather than ‘beneficial ownership’ in the underlying business.
The Chinese government turned a blind eye since it is concerned with control not capital.
A typical VIE structure is a suite of contracts including equity pledge, call option and business operator agreements involving at least three entities—the actual company operating in China, a holding company incorporated in a tax haven such as Cayman Islands or British Virgin Islands to which foreign investors provide capital, and a wholly foreign-owned enterprise in Hong Kong.
The holding company can be thought of as a venture capital (VC) provider that funds the operating company on pre-agreed terms for contribution of capital, control on the operations and distribution of profits. This spectrum of choice allows for decoupling of capital from control. Moreover, VCs rarely intervene in an investee’s operations, unlike their private equity (PE) counterparts. For instance, a VC may contribute 50% of the total capital, entitling it to profits in the same proportion, but may choose to exercise no control on day-to-day management. The VIE structure further de-hyphenates capital and control. It allows investors to enjoy predetermined rate of profits without owning equity.
In 2019, India saw a total of 1,053 investment deals, of which 750 were from VCs and the remaining from PE firms. The large share of VC deals makes it tough for India to determine beneficial interest. VCs are generally established in tax-friendly jurisdictions, with investment partners from different countries.
An unintended consequence of India’s FDI framework is that it incentivises circumvention and increases compliance costs. The main impact is on start-ups, which are already on an uneven playing with larger firms that enjoy economies of scale. Many start-ups would prefer to avail the government approval route, were it not for a long processing time. It has taken India three to four months to process FDI applications, whereas the technology markets are fast-paced. For instance, edtech start-ups like Vedantu and Classplus witnessed extraordinary growth during the lockdown.
The edtech industry raised $795 million in the first half of 2020 alone, an increase of over 600% from last year. If such firms were made to wait for funding, they would have lost the opportunity to scale.
The Indian government must reduce the FDI processing time to optimise outcomes. It can establish a one-time registration system for investors availing the official approval process, in lieu of monitoring every transaction.
And instead of focusing on beneficial ownership, India can insist on residents retaining control.
According to India’s official statistics, the cumulative FDI stock from China is only in the range of $3-4 billion. However, deals reported locally suggest that cumulative investments are in excess of $12 billion. This large discrepancy is on account of routing of capital through intermediary jurisdictions. Delays in approvals under Press Note 3 will prompt widespread use of the VIE structure, and cause the gulf between official statistics and reality to widen. Going forward, India must take stock of extant restrictions on capital flows, or it may fail to even detect that which it seeks to regulate.
Pai is a corporate lawyer and Sharan is a public policy consultant. Views are personal