Investments by off-shore funds into participatory notes (P-notes) has touched the highest level in nearly seven years as foreign portfolio investors (FPIs) are pumping money into India’s buoyant mid- and small-cap stocks.
As per the latest data published by National Securities Depository Limited (NSDL), P-notes worth Rs 1.43 lakh crore were in existence as on January 31 – the highest since June 2017 when P-notes to the tune of Rs 1.65 lakh crore had been issued, data showed.
FPI advisors who spoke with Moneycontrol said there was huge demand among off-shore funds for Indian mid-cap stocks, which had seen a massive rally in the last few years. In the last one year, the BSE Midcap index has surged 65%, outperforming the benchmark Sensex which gained 27%.
The bulk of these investments have come into high growth companies in technology, green infrastructure and consumption sectors, the people cited added.
“Lot of smaller foreign funds, especially the quant and hedge funds, are increasingly showing interest to dabble in India’s mid- and small-cap stocks where there is a scope for superior returns,” said a custodian. “These funds don’t have books as large as the foreign banks and hence doesn’t make sense for them to take an FPI license with Sebi. Hence, they are taking the p-notes route.”
P-notes are synthetic investments issued by institutions who are registered as FPIs with Sebi. Synthetic positions can allow traders to take a position without laying out the capital to actually buy or sell the asset. These provide an investment avenue for foreign funds who want to take exposure to India without having to register with domestic regulators. This is because obtaining a FPI licence would increase the compliance burden since they will have to provide various disclosures and would also have to file tax returns in India, say experts. Hence, the P-note route is easier for smaller investments since the actual shares are held by the P-note issuing FPI.
In case of P-notes, the issuer buys the shares or derivative contracts that the investor wants to buy and then issues contract notes to the investor against these securities. Hence, P-notes are contracts that have Indian securities as underlying.
This increase in P-note issuance marks a sort of resurgence in the asset class, which was shunned by foreign funds until recently due to regulatory concerns. Sebi, along with the tax department, tightened the rules for P-notes due to concerns over money laundering and confidentiality in the instrument. In fact, at their peak in 2008, P-notes contributed as much as 40% of total FPI inflows into India.
“Investors attached certain stigma to p-notes in the last decade since regulators did not take a positive view on them. But the situation is changing. Disclosure of beneficial owners has become mandatory even in p-notes. Plus, there are no tax benefits for such anonymous investments. Hence, reluctance of foreign funds around them is decreasing,” said a Big Four consultant who is handling foreign investors.
P-notes, as a percentage of total FPI assets in terms of value, are gradually increasing. Currently, they account for 2.1-2.4% of total FPI assets in India, which is highest since October 2020, data showed.
Until 2017, P-notes enjoyed a much higher market share of around 10% of FPI assets in India. However, in mid-2017, Sebi issued a circular banning P-notes from taking unhedged derivative market positions in India. This implied off-shore funds could invest in Indian derivatives via P-notes if it is only for hedging purpose and hence could not punt in the Indian futures market. This restriction led to major decline in popularity of p-notes in India, experts said.
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