India’s top private equity and venture capital funds - both foreign and domestic - are writing to the government seeking clarity on its decision to put FDI investments from China under approval, said three people directly aware of the matter, requesting anonymity as the talks are private.
These funds are being represented by the industry body Indian Venture Capital and Private Equity Association (IVCA), which is drafting the document along with law firm Khaitan & Co. They will reach out to the government in the coming week.
While Khaitan confirmed the development, IVCA declined to comment
The VC and PE industry has been rocked by uncertainty, after the government's press note issued last week, became enforceable by law days later, saying that foreign direct investments from India’s neighbouring countries will be subject to approval. While China was not named, it was clearly the note’s target.
While the amendment aims to curb Chinese investors taking over Indian firms at cheap valuations, the broad, unexplained and sudden nature of the note has funds dialing lawyers frantically and scrambling to deal with its consequences. One unintended consequence is that the new law also covers venture capital and private equity funds, whose investors (limited partners) may be Chinese instititutions or high-net-worth individuals, and are now subject to scrutiny.
Large global funds such as Warburg Pincus, Carlyle, Blackstone, Sequoia Capital and Accel among others, could have Chinese LPs as minority investors in the fund, according to lawyers and investors Moneycontrol spoke to. So even if a Chinese LP will contribute to a minuscule portion of the fund, it is now subject to approval.
Legal grey area
At the heart of the debate is the definition of beneficial ownership, whose meaning changes depending on whether the Companies Act, 2013 or the Prevention of Money Laundering Act, 2002 is used as reference. The new law does not specify. Legal experts say that ideally, under this law, if a Chinese investor is the largest beneficiary from the investment, only then it should need approval.
“If you start looking at indirect benefits, then there is no limit (to regulation). Every large global fund has a Chinese LP. But if you go to that extent, it's practically impossible to do KYC and see the influence the Chinese LP has. And it is important to note that the LP doesn't influence investments. That's the investment manager's call,” said Satish Kishanchandani, managing partner at law firm Pioneer Legal.
"The funds with Chinese LPs are very nervous. What about Fund of Funds which have Chinese LPs? So I think the government will clarify and prescribe thresholds instead of a blanket no,” he added.
Whether the Companies Act or the PMLA’s definition of ‘Beneficial Owner’ should be used, Lawyers said that the PMLA has a wider scope for defining the beneficial owner. “The PMLA’s definition has already been used in other FPI cases and then for some FDI KYC cases. PMLA is a more appropriate test for determining the final beneficial owner compared to the Companies Act as its purpose is to identify the real investment source, as against Companies Act which has a narrower scope to define the same,” said Siddharth Shah, partner at law firm Khaitan & Co.
“Under this rule if a single Chinese LP does not own more than 15-25 percent in the fund, depending on the fund structure, he cannot be seen as a beneficial owner and hence should not be impacted by the new policy,” he added.
These issues and their lack of clarity are a part of the representation funds and the IVCA are making to the government. One proposal being discussed internally is to curb the new law- and that minority investments- of 25 percent or below should not need approval.
“For startups to need approval for a few million dollars of investment, sometimes not even from a fresh investor, an existing Chinese VC investing pro rata, seems very unfair and counterproductive,” said a senior lawyer involved in negotiations.
Why is this happening?
According to initial reports, the new law was due to China’s central bank - People’s Bank of China (PBOC) increasing its stake in lender HDFC via open market purchase. However, legal experts now say that such a law has been in the works for four-five years now, and that the PBOC deal could be a tipping point at best. Further, the new FDI law does not cover the PBOC investment, which falls under Foreign Portfolio Investment (FPI), lawyers said.
“The government has been looking at a rise in Chinese investments across sectors, including sensitive ones such as pharma, healthcare, technology for four-five years now. They want to monitor where this capital is coming from. Is it a quality, legitimate, well regulated player?,” said the lawyer cited above.
“Restricting Chinese investments is now part of a larger global movement,” said Kishanchandani of Pioneer Legal
Countries such as Spain, Germany, Australia, Italy have put curbs on FDI in their respective countries. None of these countries named China in their laws either although it was clearly aimed at China - a move that India followed.
The European Union as well on March 25 told its member nations to screen potential FDI investments. The US has been at the forefront of this charge, opposing Chinese telecom firm Huawei’s operations and citing it is a national security threat.
The US began to target Chinese investments from 2018 through the Foreign Investment Risk Review Modernization Act, which brought sweeping changes in the laws enabling Committee on Foreign Investment in the United States (CFIUS). Additional provisions now include checking whether a potential investor has a history of complying with US laws, whether the deal would expose US data, and whether the country looking to invest has a special interest in US assets.
As a result, CFIUS jurisdiction expanded manifold to include ‘non-controlling investment’ and real estate. It was given authority to suspend transactions and implement a new export control regime for emerging technologies. The bubbling uncertainty around Chinese money has been brought to the fore by the COVID-19 pandemic, with countries taking a nationalistic and protective stance
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