What went out of fashion in the policymakers’ books 16 years ago may soon make a comeback. Hybrid instruments i.e. non-convertible, partially convertible or optionally convertible preference shares, that were disallowed starting 2007 may be permitted soon. This will allow foreign investors more flexibility in structuring their investments in India.
The Cabinet note for introducing Foreign Direct Investment (FDI) in hybdrid instruments has been prepared, officials at the Department of Economic Affairs officials told BloombergQuint.
The move follows Finance Minister Arun Jaitley’s 2016 budget announcement that “the basket of eligible FDI instruments will be expanded to include hybrid instruments subject to certain conditions.”
As the industry awaits the release of the new rules, BloombergQuint asked experts what changes they expect.
What The FDI Policy Permits Today
Under the existing FDI policy, besides equity shares, only fully, compulsorily & mandatorily convertible preference shares; fully, compulsorily & mandatorily convertible debentures and warrants can be issued to foreign investors. This came to be in 2007, before which partially and optionally convertible instruments were permitted.
What was the reason for the change back then?
Vaibhav Kakkar, partner at law firm Luthra & Luthra said to BloombergQuint that the government and RBI had clarified in 2007 that optionally convertible and redeemable instruments issued to foreign investors were more in the nature of debt and the same would be regulated under the more restrictive ECB (External Commercial Borrowing) regime.
Kakkar explained “Seemingly, the government’s thinking was that since such optionally convertible instruments allowed investors to recoup their investments as per the terms of issuance, as well as receive a much higher rate of assured return with minimal risks, the same was not in the nature of an equity investment, which presupposes sharing of risks and rewards in the business. Therefore to treat such optionally convertible instruments on par with equity investments under the more liberal FDI policy, in their view, was not correct and accordingly a decision was taken to govern these instruments under the stricter ECB norms.”
In 2014, RBI changed the prescribed pricing method based on which a foreign investor can exit an investment in India. While the earlier policy insisted on the use of the discounted cash flow method, the 2014 regulation under the Foreign Exchange Management Act (FEMA) said any internationally accepted pricing methodology for valuation of shares on an arm’s length basis, would be acceptable as long as the non-resident investor is not guaranteed an assured exit price at the time of making the investment.
“They did not want to be prescriptive in the methodology and hence this changed from Discounted Cash Flow (DCF) method,” Vivek Mehra, executive director at PwC told BloombergQuint.
What May Change Under The New Policy
A former RBI official told BloombergQuint on the condition of anonymity that the new policy may now include optionally convertible/ partially convertible debentures as eligible instruments for foreign investments.
The coupon on such instruments may be capped and linked to the market rate.
Vivek Mehra believes this will give more flexibility to investors. “It’s the need of the hour. Maybe they want to again give a fillip to investments. These instruments become important for Indian promoters as well, particularly start-ups,” he said.
Kakkar of Luthra & Luthra disagrees.
“A position where such instruments are treated as debt under the ECB framework until conversion and upon conversion as equity under the FDI Policy would be futile as in effect there would be no change in the overall scheme under which such instruments are currently regulated. In the alternative, what may be of particular benefit to foreign investors and would be a true liberalization is if such optionally convertible instruments are allowed a time period of say 12 months or 18 months from their date of issuance, post which if it remains unconverted, ECB norms will apply. In the interim period, these optionally convertible instruments can be regulated under the more liberal FDI regime.”Vaibhav Kakkar, Partner, Luthra & Luthra
Most experts Bloomberg Quint spoke with said they don’t think the government will change its position on disallowing fixed returns on an equity investment by a foreign investor.
But even a move to expand the list of eligible FDI instruments, by including convertibles, may give foreign investors comfort that they are not exposed to the equity risk right at the beginning of their investment.