On February 1, 2022, Finance Minister Nirmala Sitharaman addressed a longpending demand of the venture capital (VC) and private equity (PE) community by announcing that the government will set up a panel of experts to examine the issues concerning the investor ecosystem. Seven months later, a high-level panel headed by former Sebi chairman M. Damodaran was formed, and tasked with suggesting steps to scale up PE and VC investments in the country.
It’s still early days for India’s PE/ VC industry. Per an Indian Venture and Alternate Capital Association (IVCA)-EY report, the industry made investments worth $77 billion across 1,266 deals in 2021. In the first half of 2022, PE and VC firms recorded investments worth $34 billion across 714 deals. More than 80 per cent of the private capital invested in India comes from foreign investors—there is no other significant source of risk capital available for the country’s growth enterprises. Foreign investors continue to invest, in the belief that India will outperform other markets.
Yet, investors and funds are grappling with ambiguity related to taxation of carried interest, treatment of long-term capital gains (LTCG), restrictive foreign pricing rules and co-investment framework, use of convertible instruments, absence of hedging and leveraging options, downside protections, and lack of a single-window system to address the issues of the industry.
PE/VC investors are of the view that the country’s regulations have not kept up with the complexities of this industry. “We make regulations unnecessarily complex, which is why 80 per cent of the capital still looks like FDI. Reforms should be [about] streamlining [processes], easing unnecessary steps and levelling the playing fields with overseas VCs,” says Karthik Reddy, Chairperson of industry body IVCA, and Co-founder and Managing Partner of Blume Ventures.
One of the primary asks from investors is to find a solution to the taxation of ‘carried interest’ or ‘carry’, that is taxed under income tax as well as GST. Carry, in VC parlance, is the share of profit general partners of a VC fund receive in compensation for the management of a fund. Bhavin Shah, Deals Leader at PwC India, suggests that the committee should consider making the “pass-through” provisions of the Income Tax Act applicable to funds to determine that carried interest retains the same character as the underlying income of the fund, similar to the practices followed by countries like the US and the UK. “Globally, ‘carried interest’ is taxed as capital gains (profit share) and not as income from services. Think of the manager as an active partner of a partnership firm and investors as passive partners. Except for payout of appropriate remuneration (management fees in case of the fund industry), profit distribution amongst partners is not treated as income from services,” he explains.
Reddy says these regulatory complexities put Indian funds at a disadvantage. “Somebody sitting in New York can do a deal much faster and efficiently, without even visiting India, at more tax-friendly terms, while the hard-raised money of an Indian fund gets GST imposition because it is based here. How do we compete?” Reddy asks.
Another long-pending demand is to bring parity in the treatment of LTCG for listed and unlisted securities. The LTCG tax rate is 10 per cent for listed shares and 20 per cent for unlisted shares. PE/VC is an asset class that invests patient, risk capital and stays for the long term, industry players say, adding that bringing parity in LTCG tax will inspire more investors to come into the industry.
Pranav Parikh, Managing Partner of PE and VC Funds at Edelweiss Financial Services, says foreign pricing rules are still very restrictive in India. “One of the things that restrict foreign-owned entities in this country is that they are considered foreign-owned and controlled even though all their capital is in India and it never leaves the [country’s] shores,” he says. He also calls for hedging and leveraging to be allowed in the AIF structure.
Manav Nagaraj, Partner-General Corporate at Shardul Amarchand Mangaldas & Co., adds that the Damodaran-headed panel should also look into issues related to convertible instruments, downside protection, ease of investment and exit and ease of fund formation. It should also introduce global best practices, he adds.
Rashi Kapoor Mehta, Partner at Universal Legal, also calls for better clarity on the use of convertible debt structures and SAFE (simple agreement for future equity) notes by angel platforms. “There are platforms doing investments via SAFE notes and compulsorily convertible debentures (CCDs). What checks and balances… [have] these platforms… [put] in place?” she asks. CCDs are debt instruments that have to be mandatorily converted to equity shares at a later stage.
Mehta adds that while angel funds have a different set of criteria for investors, they need to be drilled down further to accommodate participants with smaller ticket sizes. She also expects some employee-friendly regulations for ESOPs. The panel, Mehta adds, should bring clarity to the concept of round-tripping, which refers to funds channelled through foreign firms as investments by resident investors that ultimately return to the origin under the guise of foreign investment.
Vijay Lavhale, Co-founder of venture debt marketplace 8vdX, agrees. He says high-net-worth individuals (HNIs) are unable to invest in offshore funds that invest in Indian start-ups due to round-tripping regulations, even though they are allowed to invest in offshore venture funds using the liberalised remittance system (LRS). “Therefore, only ‘plugged in’ angels, who have access [to ventures] can invest in tomorrow’s unicorns—especially those that are incorporated offshore. Regulations should be eased to allow HNIs to invest in offshore venture funds that make investments in Indian start-ups.”
Lavhale points to another pain point: foreign venture debt providers incur additional costs because of the tenure terms in the current structure. “[Such] investors… are treated the same as [those who provide] non-convertible debentures (NCDs) to large corporations,” he says, adding that these carry restrictions on minimum tenure such that only 30 per cent of an FPI’s portfolio can be in short-term instruments of less than three years’ maturity. Since most venture debt investments are of 18 months’ tenure, FPIs have to set up a local fund structure (AIF) increasing legal, compliance and operational costs.”
Jidesh Kumar, Managing Partner of corporate law firm King Stubb & Kasiva, calls for the creation of a separate regulator for the private market. “There must be a separate regulator for AIFs as Sebi, in its current setup and avatar, doesn’t understand private market dynamics as well as it understands the public market. In the private market, the risk-reward programme is [more] aggressive, with a lot of responsibility on Sebi as the public market regulator to preserve investments due to the diversity of the investors in the public market,” he says.
The six-member committee— that has former Sebi whole time member G. Mahalingam; former CBIC member D.P. Nagendra Kumar; former principal commissioner of income tax Ashish Verma; Poonam Gupta, Director General of National Council of Applied Economic Research; and P.R. Acharya, Director of Arun Jaitley National Institute of Financial Management—as its other members, is evaluating the recommendations made by IVCA and other industry bodies. Damodaran declined to participate in the story, saying that the committee had just started its work. According to industry sources, the committee aims to present a number of recommendations to the finance ministry before the Budget deliberations start. It is expected that some of its recommendations will make it to next year’s Budget document.
Globally, institutional capital drives the alternative investment landscape whereas in India, HNIs and family offices are driving its adoption. A friendly regulatory environment can attract a lot more domestic institutional capital to this asset class and also draw more family offices to create AIFs, which will bring more capital under regulatory ambit. At a time when investor sentiment towards startup funding is pessimistic, positive regulatory reforms can help lift the mood of the ecosystem.