Revisiting the Foreign Venture Capital Regime

In a previous post on this blog about four months ago, we had extolled the virtues of an economy possessing a favourable venture capital regime. We had also highlighted some of the progressive developments in the Indian venture capital market that were induced by favourable regulations issued by SEBI and RBI.

However, the perception of regulators in respect of venture capital firms (especially the foreign venture capital investors) has taken a drastic turn lately, and the picture is beginning to look somewhat gloomy. Over a week ago, we wrote about the possibility that the foreign venture capital route is likely to be restricted to a few sectors only, following pressure from the RBI. The fear on RBI’s part is likely to have been triggered due to the fact that foreign direct investments (FDI) is coming into certain sectors as foreign venture capital investment (FVCI) thereby not only taking advantage of the more benevolent FVCI regime but also overcoming some of the obstacles posed by the FDI regime. The bone of contention here is the real estate sector, where FDI is subject to greater regulation than in other sectors.

A recent column by Richie Sancheti and Vikram Shroff in the Economic Times notes:

“… RBI has been uncomfortable with FVCIs having low-capital base, circumventing takeover guidelines and round-tripping of investments, and has therefore also suggested that SEBI set up screening mechanism for all FVCI applications. In the interim, most of the applications have been kept on hold without any clarity on the time frame.

The intention behind introducing the FVCI regime in 2000 was to provide FVCIs a favourable environment with respect to their investments in India compared with foreign direct investment (FDI) and create a level-playing field between domestic and overseas venture funds.

FVCIs are accordingly entitled to certain benefits, including exemption from entry and exit pricing norms, exemption from any lock-up restriction, post-IPO (subject to certain conditions), and exemption from applicability of the takeover code in the event of sale of shares back to Indian promoters (and not generally). RBI seems to have developed some concerns on the nature of the applications received and investments under the FVCI regulations. …”

The column then goes on to discuss each of these concerns separately, and seeks to allay the fears of the regulator.

Ajay Shah deals with this issue from a broader perspective of financial market regulation and “rule of law”. He says:

“I am worried that there is a problem of rule of law here. What appears to be going on is that applications are not being cleared even though they are compatible with the existing policy framework. If the policy framework is a problem, it should be changed. But at all times, the letter of the law must define how government agencies operate. Similar problems seem to have arisen earlier with RBI’s treatment of external commercial borrowing (ECB) also.

Running any system of capital controls, in the modern world, is messy. There will inevitably be a arms race where the bureaucrats will come up with new controls and the private sector will use technological and financial sophistication to evade these controls. Good countries wake up and understand that this spy vs. spy contest is pointless, and shift over to full convertibility. While we are in the process of getting there, the least we should aspire to is to not do violence to the idea of rule of law.”

I couldn’t agree more. Even when capital controls operate in India as they do now, certainty of the law and clarity (to the extent possible) in its interpretation serve important roles in furthering economic development. The regulatory effort ought to be to preserve certainty and clarity, and to avoid ambivalence and nebulousness in policy for foreign investment.