No Takers For FDI In Multi-Brand Retail?

It has been six months since the UPA government put its very existence on the line to throw open the doors to foreign direct investment (FDI) in multi-brand retail. Six months and no takers yet! Which is not to say nobody is interested, but the investment, sourcing, State by State approval conditions that accompany a 51 percent foreign investment have made life tough for retail businesses, foreign investors and very busy for consultants and lawyers. Two of them join me today to talk about why there are no takers yet for FDI in multi-brand retail and the structural challenges facing such potential investments. Karan Singh, Trilegal and Paresh Parekh, EY join us to answer that.
 
Doshi: I have seen no proposal make it to the Ministry in the last six months – am I right or am I wrong? Are we still a long way of from an actual concrete proposal seeking permission to take benefit of this policy liberalisation?
 
Parekh: I think there are no proposals yet. There are some discussions going on but you just see the kind of conditions and again there are interpretation issues on those conditions.

Investment: USD 100 million whether it is bullet, whether it has to be over a period of time. 50 percent backend investment. Surprisingly, it is 50 percent of FDI so if somebody brings USD 1,000 million, he is mandated to do USD 500 million. To add to the problem, some States are not on board; as you are aware only nine states and one Union Territory is on board. If one really has to go for such an application, one may have to create possibly three companies. Company 1- where you have the foreign direct investment in retail. Company 2- which is a company which will run stores in States which are not on board or will run businesses which are not compliant with those conditions. Company 3- where the foreign investor can take up to 100 percent and run Cash & Carry. To complicate this, you have a 25 percent restriction on the supply from Cash & Carry to these companies assuming they are group companies and hold on, they have not defined what is group company. Informally we know that they are likely to go by the foreign trade policy of 26 percent role or a 50 percent board.
 
Imagine, if one has to ask the supplier or the P&G’s of the world to supply to three companies. One to Cash and Carry, one to Indian FDI retail company, one to Indian non FDI retail company; it is a mess. There is replication of invoices; it is difficult to manage the economics and to add to the problem, what if I have to invest part of the money to buyout as a secondary deal. Is it going to be counted for USD 100 million? No clarity. I think there are lot of issues around sourcing again where unlike single brand where I can procure 30 percent from India, here only 30 percent has to be procured but from small industries. These are industries where only one million plant and machinery investment is allowed. It is interesting to note, that Finance minister in the Budget speech has mentioned that benefits will be available for three more years even if they pass the one million test.
 
FDI IN MULTI-BRAND RETAIL
51% foreign investment in Multi-Brand retail permitted under the Government approval route
 
FDI IN MULTI-BRAND RETAIL
Investment Conditions
Foreign investor to infuse minimum $100 million
50% of total investment to be deployed in back-end infrastructure within 3 years of investment
 
FDI IN MULTI-BRAND RETAIL
Sourcing Conditions
Minimum sourcing of 30% of manufactured/processed products from SMEs (units with gross value of investment in Plant & Machinery not exceeding $1 million)
 
FDI IN MULTI-BRAND RETAIL
Final decision to permit setting-up of retail outlets left to the State governments
Outlets may be set-up in cities with population of more than 1 million (including area of 10 kms around the municipal/urban limits)
 Allowed in 9 states, within which there are 20 cities with population of over 1 million
State government can decide to allow outlets in cities not meeting the specified criteria
 
FDI IN MULTI-BRAND RETAIL
Cash-and-carry companies cannot supply more than 25% of their turnover to group companies
 
Budget 2013-14
MSME benefits to continue up to 3 years after MSME threshold has been crossed Doshi: So when you exceed your size limitations you might still retain the qualification of small industry for three more years.
 
Parekh: But it is not clear whether it will be extended to FDI or not.
 
Doshi: This sounds like paradise for lawyers and consultants; doesn’t it? There are so many different structures that you have to work with to try and make this viable. Is that possible or you will believe as of now it is a no go.                                       
 
Singh: Much to everybody’s surprise, lawyers don’t necessary thrive on uncertainty. If one does not have enough capital coming into the country, everyone suffers. I think this whole policy was created for political expediency. I don’t think enough seriousness or thought was given into creating this policy framework and it needs a major overhaul. I think we have alluded to the right sets of issues and we are going to continue to see an environment where there are no applications coming in for FDI yet, until the government takes the issues that have come up, more seriously. I think until the general elections; in any case, we don’t expect to see any further clarifications.
 
Doshi: You are saying all the way up to middle of next year most investors will hold back because they would like to see the outcome of those elections before they decide to invest.
 
Singh: That is absolutely right. I think one of the major factors for that is the opt-in ability for State governments to participate in this FDI framework. I think the big risk that most foreign investors feel in that specific context is that if there is a change of political climate in the State, there is a serious risk of business interruption.
 
Doshi: That could be an ongoing threat because that could continue or persist as and when we see different States go to elections. Today a State may have said yes to FDI, tomorrow if a new political dispensation says no to FDI, your compliant structure becomes non-compliant. But that would be a country going back on its words or a State government going back on its words. I doubt anybody will push it to that extent – is that as extreme a threat?
 
Singh: I don’t think there will be specific Executive action to remove the restriction or to opt out after one has opted in but people could make life difficult
 
Doshi: And impose further restrictions?
 
Singh: Or just make it difficult on the ground, as it has happened in the past with Indian retailers. In States where they didn’t want big retail to come in, we have seen that happening before.
 
Doshi: I am sure that the two of you between yourself and your various teams and lawyers and consultants across the county are trying to see if there are possible structures that could and I won’t use the word side step but that could walk through this minefield of complex regulation without going up in flames. Let me try and open with the example of an existing foreign Indian joint venture in the Cash & Carry space (Refer to Diagram 1). If that Indian foreign joint venture now wants to extend that relationship into front-end retail how would they do it? How would they do it while keeping all of these conditions in mind?
 
Diagram 1                         Diagram 2                               Parekh: (Refer to Diagram 2)
Few options would be that if there is a retail partner involved already with the Cash & Carry player, a part of the FDI compliant business can be de-merged for example into the Cash & Carry company itself, that could be one model. Alternatively, the part of the compliant business can be sold into the Cash & Carry company; of course valuation will have its own play but there will be lot of on ground issues like stamp duty on lease. Most of the players have 100 plus stores and to get them to transfer to the new company is really a difficult task. (Refer to Diagram 3)Similarly, there can be other structures where the retail company which is compliant can be pushed under the Cash & Carry company so that the valuations of the Cash & Carry company is also captured plus the retail company is also captured. That could be model number two. To slightly do a variation, the FDI compliant retail company which is in States which are allowing FDI can maybe franchise the brand and have a franchisee which is owned by the Indian company run the stores in the States which are not allowing FDI funded retail stores to open. The issue which will arise in most of these structures is the restriction of 25 percent supply from Cash & Carry to a group company. Hence, the Cash & Carry company on some supplies may have to earn commission instead of routing the sale through the Cash & Carry company. So the supplier supplies directly to the retailer and for that there is a commission which is earned by the Cash & Carry company. But hold on. Then there is a leakage. There is a service tax issue so you add up 12.36 percent on that commission charge to the whole cost. Diagram 3                         Doshi: It is cost inefficient?
 
Parekh: It is cost inefficient.
 
Doshi: Would you say that instead of an exiting structure having to migrate to something as complex as this where you break up what you have and redesign the entire blue print, that it would be easier for absolutely new ventures to go into business – so is it possible the first approval that we may see here, the first application that we may see is of the new foreign investor who is not currently invested in India, entering India through an existing Indian front-end retail chains.
 
Singh: In the long-term, it isn’t more viable. I think in the short-term there maybe certain efficiencies to starting afresh because you don’t have to reengineer entire existing structure so the corporate regulatory tax and other inefficiencies that are associated with unbundling something and then recreating it will not exist there but in the very short-term once the business is live and operational the same set of issues will come in. Unfortunately, the States that are bought in aren’t in clusters- in terms of those who have bought in and those who have opted out.
 
Doshi: Those challenges, the State challenge stays the same, 25 percent challenge remains the same.
 
Singh: The sourcing challenge remains the same, the capitalisation challenge remain the same. The e-commerce, inability to do e-commerce challenge remains the same and remember a lot of these international retailers eventually want to go the e-commerce way and that is a big issue for them.
 
Parekh: Possibly there is one advantage which can be seen for the new players - for the players which have already invested in Cash & Carry there is a real question whether the investments which are already gone whether they will be counted as satisfaction of the USD 100 million condition.
 
Doshi: They will not. Let us assume that was what you invested in Cash & Carry – if you want to invest in multi brand retail, it is a fresh $100 million
 
Parekh: In that case still, for a greenield venture there could be an advantage because when you do a Brownfield kind of a deal, it is still open whether the amount which you pay to the existing promoters for buying out the business, that  would be counted as FDI investment under the regime. So, that is still an open question.
 
Doshi: It is interesting. You are saying if an FDI player comes into an existing Indian retail chain and I am guessing that is what you consider as Brownfield how would that USD 100 million condition be met.
 
Parekh: To add to that problem, 50 percent of that FDI has to go into backend and if you are paying someone for purchase of shares how to calculate that. Will you count the earlier expenditure which has been incurred by the Indian company which has already invested into backend as partial satisfaction of that condition – still open to interpretation.
 
Singh: I don’t think the government has created a structural framework that encourages or facilitates people taking the economics out of the retail venture because of all the difficulties associated with the guidelines, people are going to be forced...(Interrupted)
 
Doshi: What do you mean by taking the economics out of the retail?
 
Singh: If you can’t put your capital into the multi brand retail venture because of all the restrictions that seemingly apply, it is going to facilitate or create an environment where the Indian partner is force to stay in the front-end and the foreign JV partner is forced to stay at the backend.
 
Doshi: What if both are new?
 
Parekh: Imagine, that an Indian partner who is a new partner for the retail venture does not have deep pockets and FDI is needed even for setting up new stores and in the business lot of expenditure happens on opening up new stores for security deposits, for makeovers and so on. Question is – how are you going to channelize part of FDI which is 50 percent which is not meant for backend but for front-end, how do you channelize that to the retail company. Then you have to come up with fancy structures. One of the options could be yes, some genuine franchisers do pay store opening fees. Each time the franchise opens a store opening fees but it will all depend on case to case.
 
Doshi: When you say fancy structure, I can see you have some fancy structures laid down in front of you. You want to take us through what some of the possibilities are.
 
 Parekh: If you look at this structure - where the foreign company wants to acquire or capture the stake or consolidate the value of the retail business into the Cash & Carry company so you actually hold the retail company below the Cash & Carry company again which is FDI compliant and you have a Indian company running a separate, completely Indian retail company, you can build streams of payment by having the Cash & Carry supply to the Indian retail company but the role of Cash & Carry (interrupted)
 
Doshi: But would the Indian company be invested in this retail company because the foreign company can invest only up to 51 percent.
 
Parekh: Under this model there is an advantage, The Cash & Carry company and the Indian retail company will not become a group company because there is no 26 percent.
 
Doshi: Who is the Indian investor in the front-end retail here?
 
Parekh: There either has to be a separate Indian company...(Interrupted)
 
Doshi: Now you are talking about two Indian investors; which can be either brother and sister, mother and father, aunt and uncle.     
 
Parekh: Not necessarily brother and sister. It can be an independent person.
 
Doshi: This seems viable to you
 
Singh: It seems viable. Clearly the one issue is if the company, the Cash & Carry company, has to be Indian owned which means the foreign company can only take a minority stake in that- otherwise it becomes a foreign company subject to the FDI guidelines and then the whole ownership in the retail company with the attended problems comes into play. It is not entirely capturing what the foreign investor would want to do
 
Parekh: In that case you would have to go for this model -where there is an Indian company where the foreign company is less than 50 percent and the Indian company is more than 50 percent and Indian company is controlling the board. In which case it becomes Indian holding and it can be an operating company and then this company can do a down stream investment and if this model is followed there is an interpretation that this is not FDI. The investment made by Indian company which is owned and controlled by Indian is not FDI and if this interpretation is accepted, there is a huge benefit. None of their conditions apply.
 
Doshi; I understand that. That means you have to find a foreign investor who is willing and happy to settle for less than 51 percent stake.
 
Parekh: Today the regulation allows only up to 51 percent
 
Doshi: 51 percent still amounts to some degree of control, so less than 51 percent or less than 50 percent will not amount to control.
 
Singh: A lot of these structures are similar to what happened in the telecom space 10 years ago. We are creating the entire environment or the government is facilitating the re-creation of that environment. We all know what happens when you drive people to adopt....(Interrupted)
 
Doshi: In this structure you would have some sort of side agreement between these two guys. If we were to go back to the telecom structure whereby he has only 49 percent but he has a bunch of other rights that protect his money.
 
Singh: That is difficult now in this environment because the government has repeatedly said that any arrangements that result in ceding control would be considered as a majority interest.
 
Doshi: Then why would he bring in 49 percent, lend his brand and all of that; only to be denied control and deny majority of economic rights.
 
Singh: That is why it is going to be difficult, that is why you are not seeing applications
 
Parekh: Just a solution, thinking from a solution perspective- if the foreign company has less than 50 percent, it can have still one more 100 percent Cash & Carry company through which depending on the functions performed by Cash & Carry company some of the economic activity related benefits will be lying there.
 
Doshi: Since you have got several structures out there and diagrams, if these solutions are available there is not a single application as yet.
 
Parekh: Because these put or have a lot of practical, on-ground business issues. This creates lot of supply chain issues. This kind of structures create, are open to uncertainty – how will the government interpret whether it is okay for these kind of structures, not okay for these kind of structures but today the biggest issue which is worrying is actually State governments going back on their word. Once you get that kind of things sorted out, you will see some applications going in. However, with a business plan which possibly requests the government to have a liberal interpretation of the conditions.