Budget 2020: Please Allow Offshore Indian Fund Managers To Return

While there has been some welcome progress in easing red tape for foreigners to invest in India, notably the recent 2019 FPI Regulations implemented by SEBI, our regulatory system continues to obstruct foreign investment. SEBI’s recent steps to merge three categories of FPI into two, to rationalise KYC requirements, and to remove restrictions on investment funds that operate from well-regulated jurisdictions are tangible actions that welcome capital into India. However, despite these steps in the right direction, discrimination against Indians continues. Current regulations make it all but impossible for a resident Indian to manage a global fund from India.

An Indian managing his fund domestically creates a Permanent Establishment or Place of Effective Management in India, which causes the global income of the fund to be taxed in India. Assume, for example, that an American investor invests in a fund managed by an Indian from India. If this fund invests in stocks outside of India, this American investor will have to pay Indian taxes on profits resulting from these global investments – even though the American investor is not a resident in India. Such an onerous tax regime is hard to find in major developed financial markets. Why would a foreign investor invest in a fund managed by an Indian in India if it must pay an extra layer of tax?

In 2016, the government took initial steps to remedy these issues via changes to Section 9A of the Income Tax Act, 1961, which provides a potential safe harbour for managers. In the 2019 budget, Finance Minister Nirmala Sitharaman announced some further minor changes. However, there remain critical challenges that prevent fund managers like me from moving to India. Here are the key hurdles outstanding, the potential thinking of the government behind those views, and some proposed solutions.

1. Existing Regulations Prevent Funds From Investing Over 20 Percent Of Corpus In Any One Investment

Under this restriction, if a fund buys a stock and it goes up in price, the fund needs to sell its investment the moment it comprises more than 20 percent of the fund. Alternatively, if the value of other investments in the fund decline, the fund may need to sell a stock that was originally below this 20 percent limit, but now exceeds 20 percent of the fund’s corpus. The substantial risk of adverse tax treatment that could result from market fluctuations entirely outside the fund manager’s control creates a significant impediment to setting up a fund in India.

Two potential concerns may have led to this restriction.

First, there is the concern that having such a large percentage of a fund in one company’s securities indicates that the fund may have some sort of professional affiliation with the company, and may even potentially have inside information. This ignores the fact that respected investors around the world frequently take concentrated positions based on publicly available information, and that it is not uncommon for a fund to have investments cross this 20 percent threshold over the course of its lifetime. Indeed, making large, concentrated positions is the bread-and-butter of long-term, fundamental research-driven public markets investing. Concerns around corporate governance, inappropriate or undisclosed professional relationships between investors and their portfolio companies, or insider trading should be addressed through strict enforcement of the existing laws and severe penalties for those who violate them.

Second, there is the concern that a fund with a 20 percent position is not sufficiently diversified. Investors and asset allocators spend substantial time and resources understanding and selecting their managers. Many investors and asset allocators favour mangers who exhibit high conviction in their investment ideas through significant concentration.

This rule should be removed entirely.

2. Existing Regulations Limit Resident Indians To Investing 5 Percent Of Fund’s Corpus

Almost all startup funds see the founder put a substantial part of his net worth in the fund. This is an established global practice expected by a fund’s potential investors. In many cases, the founder remains above 5 percent of the corpus for many years of the fund’s life as the fund ramps up in assets under management. Key employees of the fund, who would also be resident Indians, are also frequently expected to invest in the fund per industry practice. In some of the largest and most well-established global private investment funds, key employees collectively comprise well over 5 percent of the fund’s corpus.

It helps promote long-term investing and reduce the agency problems that so often plague the investment management industry. The current rule prevents both startup funds and larger well-established funds committed to this important alignment of interests from moving to India. There are similar restrictions by SEBI as well as the RBI.

The key concern that may have led to this restriction is a fear of ‘round-tripping’ of funds specifically funds from illicit domestic money being moved offshore and reinvested in India via FPIs, thus avoiding taxes. India already has an extensive legal framework to tackle the problem of illicit money, this legal framework can be applied to address any concerns regarding abuses of the FPI system by illicit money.

In order to allow funds to start and stay in India, resident Indian employees of a fund should be exempt from the 5 percent threshold and other similar restrictions set by SEBI and the RBI.

3. Funds Must Have Monthly Average Net Asset Value Of Rs 100 Crore

This does not allow a startup fund with a lower size to begin operations in India. At best, the regulator gives between a few months to a year for the fund to achieve this threshold, which is too short by industry standards. Some of the most successful investment firms were started with less than $1 million or Rs 7.1 crore of capital and built into several billions of dollars over several years.

It is not clear why this rule exists. One potential reason could be that having a lot of smaller funds could put a heavy monitoring burden on the regulator. I believe the best way to address this concern is to discard the Rs 100 crore limit and instead charge higher fees to smaller funds that want to set up. This creates a more moderate barrier for smaller funds instead of an outright ban, thereby allowing small funds who are willing to bear the risk and cost of setting up a fund to operate from India without placing an undue burden on the regulator.

After working at two very well-reputed investment firms outside India over the past 10 years, I recently decided to set up my own investment firm which—while focused on India—invests in markets all around the world. My hope, that was thwarted by the above regulations, was to do this from India. Our country’s biggest resource is not oil or coal or an industrial base. Rather, our strength is our intelligent and resourceful people who bring their entrepreneurial spirit to all corners of the world. Good investors promote good corporate governance, innovation, and sustainable business practices by directing capital to opportunities that provide attractive long-term returns. Good investors help ensure that markets do their part to promote a country’s prosperity, working hand-in-hand with government.

An established fund management industry can lead to tens of thousands of well-paying jobs, which directly helps the economy. Today, New York, Hong Kong, London, and Singapore are benefiting from the enormous talent of non-resident Indian investors who have set up their funds in those geographies. With only modest changes in regulation, India can attract talented investors, the well-functioning markets that they help promote, and the substantial tax revenue and employment that they bring with them. We only need the regulations to cease treating resident Indians as secondary citizens in the investment profession.

Rohan Agarwal is Managing Partner and Portfolio Manager of Hara Global Capital Management LLC.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.