Funding ‘Make in India’

Now that the government has embarked on the ‘Make in India’ journey, it is probably the right time to look at a critical factor for making it happen — capital supply.

In India, efforts to increase the flow of equity capital to domestic businesses have usually fallen between two stools. Either there is heavy reliance on foreign portfolio flows, or intermittent efforts to coax reluctant retail investors to take on equity risks through Initial Public Offerings.

Encouraging high networth investors and domestic institutions to invest in risk capital in emerging enterprises offers a far better solution. The venture capital/private equity industry has been an excellent conduit for such investments in recent years. Yet, the enabling policy environment for this industry is largely missing.

In the past 10 years, the VC/PE industry in India has provided $80 billion in equity funding to over 2800 enterprises spread across 12 sectors. These funds, investing at a run rate of $7-10 billion annually, have supplied twice the capital supplied by the IPO market in the last five years.

Venture capital funding has proved to be a far more reliable source of capital for small businesses than either IPOs or foreign portfolio money.

Venture capital is the only significant source of capital for startups and young-and-growing companies. Almost 90 per cent of PE transactions are in unlisted companies. Such deals account for about 70 per cent of the PE capital deployed. In deals under ₹60 crore, about 85 per cent of the PE capital is deployed in unlisted companies.

PE and venture funds provide not just capital, but several other tangible and intangible benefits to investee companies. For one, by actively engaging with small enterprises and providing them with regular strategic and managerial inputs, PE firms improve their profit and growth parameters and enable them to compete in the global marketplace.

At a recent industry conference, it was stated that PE-backed companies managed to grow their export income by about 20 per cent annually between FY05 and FY13, compared to the 16 per cent managed by their non-PE-backed peers.

Venture-funded firms also engaged in more cross border M&A and delivered much higher rates of revenue and operating profit growth in the years immediately following the funding.

PE-backed firms also generated substantially higher employment due to their improved ability to scale up and move up the value chain. It has also been found that PE-backed firms saw their direct employees grow by about 13 per cent in the immediate five years after the PE investment. This was four times the 3-per cent employment growth for their peer firms.

Finally, the role of professional PE and VC investors in improving the governance standards of family-owned businesses cannot be gainsaid.

Not only do PE investors usher in independent audit, compensation committees and better reporting standards to investee firms, they also bring about fewer instances of loan default by imposing greater credit discipline. It has also been demonstrated that PE-backed small enterprises contributed more actively to the exchequer by paying much higher corporate taxes (almost twice as much) than their other peers.

This presents a strong case for encouraging larger numbers of Indian businesses to explore the PE route for their capital and managerial needs.

In order to support the ‘Make in India’ initiative, it is critical to facilitate and help the PE industry and fund managers in ‘Managing in India’.

Broadly, this can be done by addressing three critical issues: reducing complexity in taxation by restoring the tax pass-through for all PE/VC funds; allowing and facilitating domestic capital pools to invest in PE/VC; and making it simpler for fund managers of India-focused foreign investors to operate from India by clarifying non-applicability of permanent establishment.

Apart from a lack of awareness about their return potential, one big factor that holds back domestic investments in alternative investment funds (AIFs) is the lack of clarity on taxation. Under the Venture Capital Funds Regulations 1996, tax pass-through existed for all venture capital firms.

In 2012, new AIF Regulations were introduced and funds were categorised into three types of AIFs. Due to harmonisation issues at the time of introduction of the new regulations, pass-through was given to only a sub-category of Category I AIFs, taking away pass-through status from funds that had it under earlier regulations.

In the absence of tax pass-through to AIFs, taxation is applied at the maximum marginal rate at the investment vehicle level. This leads to compromise in the tax status of individual investors, who may actually have special tax statuses.

For instance, domestic institutions such as the LIC and General Insurance Corporation, and foreign investors from countries with which India has double taxation treaty often have special tax statuses, but the lack of tax pass-through results in taxation at the vehicle level at rates higher than applicable to these investors.

A restoration of tax pass-through status for all AIFs to harmonise with the status under the Venture Capital Funds Regulations 1996 should be considered.

Globally, PE funds source a good portion of their corpus from institutional investors. Insurance companies, pension funds and charitable trusts are prominent investors in venture funds, apart from high net-worth individuals (HNIs). In India, only a minuscule portion of the domestic insurance, pension or trust monies flow into PEs.

Specific investment restrictions imposed by regulators and extremely conservative investment practices of domestic institutions, are the reason. Even allowing 10 per cent of the current assets held by domestic HNIs, insurers, pension funds and charitable trusts can create an estimated $250 billion in investible capital for the AIF industry.

And this capital can be sourced without coaxing or cajoling foreign investors, incurring any foreign exchange outgo or even subjecting domestic retail investors to undue risk.

Fund managers of India-focused foreign investors remain outside India fearing that their presence in India may have adverse tax consequences by creation of a business connection/permanent establishment in India and offshore funds being regarded as tax resident in India.

The clarity on non-applicability of permanent establishment will encourage such funds to operate from India, rather than from Singapore or any other location. This will reduce transaction complexity and add to local capabilities in identifying, evaluating and monitoring investments.

Making India a hub of fund management will be tax accretive to the economy, in addition to helping the industry to grow and making it simpler and easier to invest in India. As this government prepares to put its muscle behind the ‘Make in India’ initiative, will it give the venture capital industry a chance to ‘Manage in India’?

The writer is the chairman and managing director of TVS Capital Funds

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